Now that auto-enrolment makes it easier than ever to save for retirement, it can be tempting to put off thinking about your pension. You may be getting ready to phase out of the workforce or considering how to invest for your future.
While you don’t get a choice of which type of scheme you’re a part of, understanding how they work can help you better plan your retirement. To help you get up to speed, we’ll explain the differences between defined benefit versus defined contribution pensions as well as the pros and cons of each plan.
But first, let’s start with the basics.
What is a workplace pension scheme?
A workplace pension scheme can be an important part of saving for your retirement. Like any savings plan, it helps you put money aside for the future.
No one can choose the type of plan their employer offers. But, depending on whether you’re a member of a defined benefit versus a defined contribution plan, you may be eligible to claim tax on other benefits.
What is a defined benefit (DB) pension?
Often referred to as DB pensions or final salary pensions, defined benefit pensions are a type of workplace pension. How they work is simple: the amount of money you receive when you retire is linked to the length of your service for that particular employer.
Defined benefit pensions fall into two categories: final salary schemes and career average schemes. Which you fall under will determine how much you receive at retirement. We’ll explain more about this later.
Private vs public sector defined benefit pensions
Some public sector schemes are paid out of taxpayer money. These include those schemes for NHS workers, teachers and civil service workers.
Private sector schemes typically come out of your employer’s pocket. Some private and public schemes give you the right to request a pension transfer. If this is something you think you’d be interested in, confirm whether you have this option with your employer.
Whether your scheme is private or public sector, your employer must ensure that they’re contributing enough for you to live on when you retire. Providing employees with a retirement income for life is an expensive benefit. Unfortunately, this means fewer employers offer this type of pension plan today.
How do you calculate your defined benefit pension income?
Defined benefit schemes will vary between employers. The value you receive will depend on three important factors:
- Pensionable service: How many years you’ve been a member of the scheme
- Pensionable earnings: The average of your salary during your service
- Accrual rate: Your scheme’s accrual rate is typically 1/60th or 1/80th of your salary
If you’re part of a final salary pension plan, the amount paid out is based on your earnings when you retire. And if you’re in a career average scheme, this amount might be the average of your salary during your tenure divided by your scheme’s accrual rate.
Calculating your final retirement income involves a simple formula:
((Pensionable service) / (accrual rate)) x (pensionable earnings)
For example, let’s say you’ve decided to retire at 65 on a £50,000 salary, have been a DB scheme member for 30 years and your scheme’s accrual rate is 1/80th.
Your formula would look like this: (30 / 80 x £50,000)
This means you’ll receive an annual pension income of £18,750.
When and how can you take your defined benefit pension?
Many final salary schemes allow you to start taking your pension when you reach ‘normal retirement age’. This is usually 60 or 65 and coincides with when your employer stops contributing to your pension.
Some schemes allow you to take your pension as early as 55 but be aware that taking it earlier means you will receive less than if you waited 10 years. You can also choose to defer your pension, giving yourself the possibility to enjoy more income.
Many schemes also allow you to take some of your entire pension as a tax-free cash lump sum. This could be an option for you if:
- You’re aged 55 or older
- Your pension is worth less than £10,000
- Your entire pension savings are less than £30,000
The pros and cons of defined benefit pensions
Now that you know how defined benefit pensions work, here’s a quick overview of their pros and cons:
Pros
- Peace of mind: You’re guaranteed a retirement income for life which increases annually
- Death in service: Your partner or dependents will usually receive a payout should you die before you can claim your pension
- Pension transfer option: Some private and public sector defined benefit schemes allow this.
- Added protection: Any schemes that go bust from April 2005 onwards will be covered by the Pension Protection Fund (PPF).
Cons
- Inflexibility: DB pensions aren’t as flexible as DC pensions when it comes to taking out large sums or varying the amount you take.
- Non-transferrable: If your scheme is ‘unfunded’ or paid by taxpayers, you won’t be able to transfer it.
What is a defined contribution (DC) pension?
Since 2012, all UK workplaces must enrol their employees into a defined contribution pension scheme. As the name suggests, you fund your DC pension through your own contributions when you get paid. Your contributions are also supplemented by tax relief and your employer’s contributions.
How these pensions work is different to defined benefit pensions. The amount you contribute is the known ‘defined’ part of the pension but instead of this amount building up, it’s invested in the stock market, giving it the potential to grow over time.
Your pension pot size will vary along with the fund’s performance. This is why many pension fund calculators can only provide a rough estimate of your future funds. When you reach retirement age, you have the flexibility to buy pension products such as an annuity or drawdown.
How much will you get from your defined contribution pension?
If you have a defined contribution pension, you'll know the average amount you put into your pot by checking your payslip. But what about the rest of your contribution? Many factors affect how much money you’ll get at retirement with a DC pension. How much you receive depends on:
- Your annual salary before tax
- The age you plan to retire
- How much you contribute
- How much your employer contributes
- Charges for managing your pension plan
- Your investments’ performance
To date, the total minimum contribution is 8% and includes contributions from yourself and your employer. Your employer must contribute a certain amount, which is usually 3%, while you make up the difference.
This may not seem like much, but it all adds up. For example, if you and your employer are both making the minimum contribution on your £50,000 salary, you’ll be putting away just over £3,500 each year.
When and how can you take your defined contribution pension?
Just like a defined benefit pension, you can take your pension once you reach the age of 55. This age will increase to 57 from 6 April 2028, so it’s crucial that you factor this into your budget. A financial adviser can help if you're unsure how to budget or have a complex financial situation.
The 2015 pension freedoms also mean you have the option to:
- Cash-out your entire pension pot - you’ll usually get the first 25% tax-free and pay tax on the rest.
- Leave your savings untouched - delaying retirement could help you enjoy a more comfortable retirement further down the line.
- Buy a retirement product - lifetime annuity and drawdown can offer guaranteed income and added flexibility.
The pros and cons of defined contribution pensions
DC pensions may not seem as attractive as DB pensions at first glance but their flexibility could help you enjoy more options when it comes to managing your retirement income.
Pros
- Free money: For every contribution you make towards your pension, your employer will also pitch in to help you save for the future.
- Pension tax relief: You’ll receive tax relief on your contributions based on the rate of income tax you pay. For example, if you’re a basic rate taxpayer that pays £80 into your pension each month, the government will contribute £20, helping you save £100.
- Ease of transfer: DC pensions are much easier to transfer than defined benefit pensions.
- Passing your money to loved ones: Many schemes will payout to your beneficiaries if there’s money left in your pension. How old you are when you die or whether you’ve purchased annuity or drawdown will affect how much they’ll get and how it’s taxed.
- More control: Unlike most DB pensions, you have the freedom to buy retirement products, take lump sums or leave your money to grow.
Cons
- The bulk is coming out of your pocket: Setting aside money for your retirement is always a wise decision. However, you must balance the amount you set aside with your everyday living costs and financial goals. If in doubt, seek professional advice.
- Investment volatility: Because DC pensions invest your money in the stock market, the value of your pension pot can fluctuate depending on market conditions. Bear markets can mean your pot falls in value and you may consider delaying retirement.
- Pension transfer fees: Exit fees and annual charges can deplete your pension pot.
Taking the next step with your workplace pension plan
By now you should have a good idea of the pros and cons of defined benefit versus defined contribution pension plans. Knowing the basics of your scheme will help you make informed decisions about how to manage your retirement income.
Pensions are investments. Like any investment, there’s an element of risk. If you’re concerned about affording retirement, thinking about taking a lump sum or confused about your later life options, you should seek financial advice.
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