Defined benefit vs defined contribution: how the two workplace pensions differ

There are two types of workplace pension, defined benefit and defined contribution, and the difference between them decides almost everything else: whether you end up with a guaranteed income or a pot of money, who carries the investment risk, what you pay in charges, and when you can take the money out¹.

A defined benefit pension, sometimes called a final salary or career average scheme, pays a promised pension based on factors such as your salary and length of service². A defined contribution pension is a pot built from what you and your employer pay in, invested by the pension provider, where the amount at retirement depends on how much was paid in and how the investments performed³. Defined contribution is now the most common type of workplace pension⁴.

Under auto-enrolment, the minimum that goes into a defined contribution workplace pension is 8% of your qualifying earnings, split between 5% from you, including pension tax relief from the government, and 3% from your employer⁵. Charges on the default investment option in workplace pensions are capped at 0.75% a year⁷.

Defined benefit and defined contribution: the two types of workplace pension

Workplace pensions are arranged through your employer as a way to save for your retirement, and all employers must organise pensions for employees¹¹. They are sometimes called occupational, works, company or work-based pensions¹². Within that, there are two types of workplace pension scheme, defined benefit and defined contribution¹.

The distinction is about who takes the risk. In a defined benefit scheme, the employer makes contributions and is responsible for making sure there is enough money at retirement to pay a secure income for life³. In a defined contribution scheme, your employer chooses a pension provider to invest your pension contributions, and the money paid in by you or your employer is used to buy investments¹³.

A defined benefit pension does not depend on investments; it is based on your salary and how long you worked for your employer¹⁴. A defined contribution scheme provides a pot of money for retirement instead of a guaranteed pension². All personal pensions are defined contribution schemes, so if you have a personal pension rather than a workplace one, it falls on the pot side of the line¹⁵.

If you are not sure which you have, the scheme booklet or your annual statement will say. A defined benefit workplace pension scheme promises to give you a certain amount each year when you retire¹³. A defined contribution scheme will show a fund value that moves with investment performance.

Defined contribution: a pot built from what you and your employer pay in

In a defined contribution scheme, the value of your pot at retirement depends on how much you and your employer have contributed, and how well the underlying investments have performed¹⁶. Your pension pot is put into various types of investment, such as shares¹. When you save into a defined contribution pension, your money is invested in higher-risk assets, which offer higher returns, to help your pension pot grow¹⁷.

That means the outcome is not fixed. The pot can be larger or smaller than the contributions paid in, depending on investment returns and charges over the years. Defined contribution schemes do not provide a guaranteed pension and instead provide people with a pot of money they can use in retirement¹⁸.

You can choose a nominated beneficiary who will inherit the money left in the pot, and it does not necessarily have to be a spouse or dependent¹⁹. Any money left in your pot will be passed to someone you have nominated¹⁹.

Defined benefit: an income set by the scheme rules

Defined benefit schemes pay a promised pension based on factors such as salary and length of service². The amount you get at retirement is based on how long you have been a member of the pension and your earnings¹. The pension is usually based on a fraction of your salary, multiplied by the number of years you were a member of the scheme⁵.

The result is a guaranteed income for life after retirement, based on your final salary or career-average earnings¹⁶. Because the employer carries the responsibility for funding it, the scheme does not depend on how investments perform in the way a defined contribution pot does¹⁴. Your employer must make sure their scheme has enough money to pay employees' pensions, and cannot spend the pension fund if they have financial problems¹³.

How much you get can still vary with when you take it. In one worked example, someone who started paying in at 35 into a scheme based on 1/80 of final salary would get 20/80 of final salary retiring at 55, and 30/80 retiring at 65⁵. In another, a member whose scheme retirement age was 60 retired at 58 and had their pension reduced by 10 per cent because it was paid two years early⁵.

Most defined benefit schemes will continue to pay a portion of your pension income to any of your dependents after you die, usually stopping when your partner dies and any children reach a certain age, often 18 or 23 if still in education¹⁰.

Contributions: at least 8% of salary under auto-enrolment

Under auto-enrolment rules, you must save at least 8% of qualifying earnings into a pension, with at least 3% coming from your employer²⁰. The 8% is split between employee (5%) and employer (3%)⁶. Employees must contribute at least 5% of their qualifying earnings and employers must contribute at least 3%²¹.

The 5% from you includes pension tax relief from the government⁵. What sets pensions apart from other savings or investment accounts is that you get tax relief on your contributions¹⁶. If your employer is more generous, your own share can be lower: if your employer contributes 6%, you would only need to contribute 2% to reach the 8% total minimum contribution²².

These are minimums, not limits. You can pay in more, and you would still get tax relief, but you would not benefit from extra employer contributions as you would if you were increasing your own workplace contributions²³. There is a wider debate about whether 8% is enough: the Resolution Foundation has described current policy as comprising the State Pension and auto-enrolment with an 8 per cent default contribution rate²⁴, and a parliamentary committee has launched an inquiry into who should bear the cost of a fairer pension system⁶.

Charges on defined contribution pots, capped at 0.75%

The pension scheme provider investing your pension may charge you, often an amount based on the value of the pension¹. Charges matter more in a defined contribution scheme, because they come out of a pot whose final value depends on investment growth.

For workplace schemes, the charge on the default investment option is capped. Charges paid out of member savings in default investment arrangements must be no higher than 0.75% a year of the member's fund⁸. Default workplace pension funds used for automatic enrolment are capped at 0.75% a year²⁵. The Occupational Pension Schemes (Charges and Governance) Regulations 2015 introduced a charge cap of 0.75 per cent applying to all member-borne deductions, except for transaction costs, on the default funds of schemes used for automatic enrolment²⁶.

The cap applies to the default fund, not to every fund a scheme offers, and it does not cover transaction costs. There are also limits on other charging structures: a contribution percentage charge under a combination charge structure is limited to 2.5% of the contributions allocated under the default arrangement annually, and a single charge structure is limited to 0.75%²⁷.

When you can take your pension: 55 for DC, typically 60 or 65 for DB

You cannot take money from your pension until you are at least 55 (rising to 57 in 2028), but you can do so at any point after that⁹. You can take money from your defined contribution pension when you reach the age of 55 (rising to 57 in 2028)²⁸.

Defined benefit is different in practice. You can get access to your defined benefit pension once you reach 55 years old, or earlier in special circumstances²⁹. Taking a defined benefit pension early usually reduces it: in the worked example above, retiring two years before the scheme age cut the pension by 10 per cent⁵.

Timing also changes how long the money has to last. In one illustration, retiring at 55 means a fund built over 20 years must last 30 years, while retiring at 65 means a fund built over 30 years must last 20 years⁵.

Death benefits, ill health and extras some schemes offer

The two types behave very differently when a member dies. If you die before taking your defined benefit pension, the scheme will usually pay out a lump sum to your spouse or civil partner, typically two or three times your salary³¹. Most defined benefit schemes will also continue to pay a portion of your pension income to dependents after you die¹⁰.

With defined contribution pensions, you can choose a nominated beneficiary, and any money left in your pot will be passed to someone you have nominated, who does not have to be a spouse or dependent¹⁹. Your beneficiaries can usually choose to have the fund paid as a lump sum, an income or a combination of both³². If you die before you reach the age of 75, you can usually pass your defined contribution pension tax-free to a nominated beneficiary³¹.

There are limits and conditions. A lump sum death benefit is taxable if the member or beneficiary was 75 or over when they died, or if the lump sum was not paid within 2 years of the scheme finding out³³. Legislation sets out that no lump sum death benefit may be paid other than nine listed types, including defined benefits, pension protection, uncrystallised funds, annuity protection, unsecured pension fund, charity, transfer, trivial commutation and winding-up lump sum death benefits³⁴.

On ill health, if you are retiring early due to an illness that is likely to affect your life expectancy, some providers may boost your pension⁵. If you retire early through ill-health there may be special terms in the scheme rules that allow for the pension to be enhanced⁵. You cannot usually take money from your pension scheme until you are at least 55, unless you are seriously ill²⁸.

Changing jobs, transferring and opting out

When you change jobs your pension belongs to you²⁸. You can choose to opt out of a workplace pension¹¹. Some benefits are only available to an employer's current workers, so leaving a job can change what extras you keep²⁸.

Transferring a defined benefit pension into a defined contribution scheme is the decision where the two types collide. If you transfer, you will lose the promise of a guaranteed retirement income for life with automatic annual increases¹⁰. Money left in a defined contribution pension can be left to anyone you nominate, so this option might mean more of your money passes to the people you choose¹⁰. But the effect of Income Tax and National Insurance might not make up for the guaranteed income you will lose¹⁰. Most people are better off keeping a defined benefit pension, according to the Financial Conduct Authority and the Pensions Regulator¹⁰.

There are hard rules around it. If your defined benefit pension is worth over £30,000, you will need to pay for financial advice before you can transfer it into a defined contribution pension¹⁰. If the value of your defined benefit scheme is £30,000 or above, you will have to take advice from a regulated financial adviser³⁵. If you are already receiving payments from a defined benefit scheme, you will not be able to switch to a defined contribution scheme⁷. If you are a member of a DB scheme which is not in a PPF assessment period, you might be able to transfer out your benefits into an alternative pension arrangement, such as a defined contribution pension³⁶.

If you are moved from a defined benefit to a defined contribution section by your employer, you would not build up any further service in the defined benefits scheme at the date of change, and your benefits would be calculated taking into account your salary at the date of leaving, rather than the date you transferred to the DC benefit structure³⁸. If you choose to move, you will not build up any further service in the defined benefit scheme from the day you move, and your final pensionable earnings will not take into account any salary changes after you move³⁸.

What protects you, and where protection stops

Defined contribution pensions have a ringfence. Pension companies should ringfence your pension savings, which means that if they were to go bust, your pension would be safe³⁹. That protection is about the provider failing, not about investment performance: your pot can still fall in value.

Defined benefit protection works differently, because the promise sits with the employer. Your employer must make sure their scheme has enough money to pay employees' pensions, and cannot spend the pension fund if they have financial problems¹³. If your employer goes out of business and you are in a trust-based defined contribution scheme, you will get your pension, but your pension pot might be reduced because administration costs are paid by members' pension pots¹³.

If something goes wrong, the Pensions Ombudsman can look at complaints about pensions organised by employers⁴¹. The Pensions Regulator oversees workplace schemes and the Financial Conduct Authority regulates pension advice¹⁰. Free, impartial guidance on defined contribution options is available through Pension Wise, which explains the options for taking money from your defined contribution pension⁴². If you have a defined contribution pension pot, you are eligible for that guidance⁴³.