These days, you’d be considered lucky to have a defined benefit pension. That’s because, while its benefits are considered more lucrative than the more common defined contribution pension, fewer and fewer employers are offering it to their employees. In short, defined benefit pension plans have become too expensive for employers to run.
But if you are one of the ‘lucky ones’, you might be wondering exactly how it differs from a defined contribution pension plan. And this information could be particularly helpful if you’re considering moving jobs and away from your defined benefit pension scheme.
What is a defined benefit pension plan?
Unlike a defined contribution pension, an employee doesn’t usually have to pay into a defined benefit pension. Instead, the employer covers this cost alone. They manage the investments themselves (often by partnering with a third party, like an insurance company), and it’s ultimately their responsibility to make sure the investments grow enough to cover an employee’s retirement income.
That retirement income is agreed ahead of time, when the employee joins the pension scheme. But rather than agreeing to a specific monetary amount, it’s agreed that the employee’s pension income will be calculated using a formula.
The formula might take into account:
- The number of years you were employed at the company
- Either your final salary or average salary during that time
- An accrual rate
The accrual rate represents the amount of your salary that’s added to your final retirement income each year that you’re employed at the company. It varies depending on how generous the company’s pension scheme is, and it’s either expressed as a fraction or a percentage.
Here’s an example:
- You’re employed at a company for 30 years
- Your average salary during that time was £30,000
- The company’s accrual rate is 1/50
The formula would look like this:
30 years £30,000 1/50 = £18,000 annual pension income
Depending on the type of defined benefit pension plan you have, you may be paid that amount for a set number of years or for the rest of your life.
If you have the more common workplace pension, you can use our defined contribution pension calculator.
The pros of defined benefit pension plans
Defined benefit pensions are considered valuable because they offer a few perks that defined contribution pension plans don’t. So let’s compare defined contribution vs defined benefit pension plans…
✔️ Retirement income is guaranteed
With a defined benefit pension, the employer guarantees to pay a set retirement income, regardless of how the underlying investments perform. This makes it a more stable benefit than defined contribution pensions, which - while they do tend to grow over the long-term - can be negatively impacted by the stock market and other investments in the short-term.
Even if the company goes through financial difficulties or ceases to trade, the payments are guaranteed thanks to the government-sponsored Pension Protection Fund.
✔️ Retirement income may be guaranteed for life
Although some defined benefit pension schemes pay out retirement income for a set number of years, others pay out for the lifetime of the retiree.
It means you can rest assured that - so long as the company you work for remains in good financial health - your pension will never run out, which is possible with a defined contribution pension scheme.
✔️ Retirement income is often linked to inflation
Inflation happens when the average price of goods and services rises over time, causing your money’s purchasing power to fall.
The same thing can be true of pensions that aren’t inflation-linked. If you continued to receive the same amount of pension income every year, you’d be able to buy less and less with it over time because inflation will ‘erode’ its purchasing power.
Defined benefit pension plans are often - but not always - guaranteed to rise with inflation, or at least to a predetermined amount that makes up for inflation to some extent.
So while you may receive £15,000 in the first year of retirement, it could rise by 2% the following year - if that was the rate of inflation - to £15,300.
✔️ Employees don’t usually need to make contributions
With the more common defined contribution pension plan, employees are required to contribute at least 5% of their salary. But with defined benefit pensions, all contributions are usually taken care of by the employer.
This leaves the employee with more money in their pocket at the end of the month, which could be used to make further investments into a personal pension. This could be an effective way of boosting their pension income, since it’s not possible to pay in extra money to a defined benefit pension scheme.
✔️ Your next of kin could receive a portion of your pension income if you die
If you want to leave your partner or child some financial security when you die, a defined benefit pension may remove some of the uncertainty.
Often, a defined benefit pension will continue to pay out a percentage of your retirement income to a beneficiary when you die. But it could also pay out a lump sum, which is often calculated as a multiple of your average of final salary - if you die before you turn 75, this should be tax-free.
The cons of a defined benefit pension
Defined benefit pensions are highly regarded for many good reasons, but they do have some downsides.
❌ Employees don’t have control over investments
With a defined contribution pension, employees often have more freedom to choose how they invest their pension. This might be particularly important, for example, if you want to pick investments that align with your values or investments that you believe have higher potential for growth.
But defined benefit pension plans are managed by the employer (or delegated to a partner), which could see them grow at a slower rate. And this could influence the amount of retirement income the employee would receive in retirement, depending on the type of agreement they have.
❌ Less flexible drawdown options
When you reach retirement, a defined benefit pension will pay you a set amount of income every month.
However, a defined contribution pension would allow you to:
- Choose how much income to draw down each month
- Choose how frequently you draw down from your pension
- Take out a large lump sum
- Leave your savings invested, with potential for growth
If you did want to access the money in your defined benefit pension in these ways, you could transfer it to a defined contribution pension plan. But a defined benefit pension transfer could result in lost benefits including lifetime payments, and you could receive less overall.
❌ You could receive less if your employer experiences financial difficulties
Unlike a defined contribution pension, which is primarily the employee’s responsibility to maintain, a defined benefit pension plan is the responsibility of your employer. So if the employer goes bust or experiences financial difficulties, your retirement income could be negatively affected.
The government-sponsored Pension Protection Fund (PPF) can make up a portion of your pension income if your employer falls into financial difficulties, but you may not receive the full amount as you were promised.
❌ You might not be able to access it at 55
Defined contribution pensions typically allow you to start taking money out from the age of 55 (rising to 57 in 2028). This can be helpful if you’ve saved enough to retire early or simply want a cash boost to fund major purchases or to pay off debt. However, defined benefit pensions typically allow you access to your savings from the age of 60 or 65 (some may allow you to access it earlier).
Of course, you might not want to access your pension at 55 - the longer you wait, the more your pension is likely to be worth.
❌ There’s less choice when it comes to appointing beneficiaries
Defined benefit pension schemes typically allow you to pass on some money to your family or dependents when you die. But you usually can’t instruct your employer to pass your defined benefit pension on to a person or people of your choosing, unlike a defined contribution pension scheme.
Are defined benefit pensions good or bad?
Different types of pensions suit different people, so we can’t really say whether defined benefit pensions are good or bad. They simply have their pros and cons.
On the plus side, defined benefit pensions have many valuable benefits:
- Employees don’t usually have to pay into them, leaving more money to spend
- Retirement income is guaranteed and can be for life
- Income is often linked to inflation
But they also have their downsides:
- Employees can’t choose their plan
- There are limited drawdown options
- If an employer experiences financial difficulties, the employee may receive less
If you’re unsure, you might want to speak with an expert about your situation. And if your defined benefit pension is worth more than £30,000, you’ll need to seek independent advice before transferring it.
Ultimately, you’re unlikely to be able to choose between a defined benefit or contribution pension. So you’ll simply need to make the best of whichever one you receive from your workplace.
Risk warning As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.
Last edited: 06-04-2024
