Defined Contribution vs Defined Benefit

The key difference

The fundamental difference between the two types comes down to who bears the investment risk and what is guaranteed at retirement.

In a defined contribution pension, the risk sits with you. Your contributions and your employer's contributions are invested, and the value of your pot at retirement depends on how those investments have performed. You could end up with more or less than expected.

In a defined benefit pension, the risk sits with your employer. They promise to pay you a specific income in retirement, regardless of how the underlying investments have performed. If the scheme's investments underperform, the employer must make up the shortfall.

Defined contribution pensions

With a defined contribution pension, every pound contributed, by you, your employer and the government through tax relief, goes into your personal pension pot. That pot is invested in funds chosen by you or, if you don't make a choice, in the scheme's default fund.

The value of your pot grows (or falls) in line with investment performance. When you reach retirement, you can use the pot to generate an income in a number of ways, through drawdown, an annuity or a combination of both. You also have the option to take up to 25% of your pot as a tax-free lump sum.

Defined contribution pensions offer flexibility, you can choose how and when to access your money from age 55 (rising to 57 in 2028). However, the income you receive in retirement is not guaranteed and depends on how much you have saved and how your investments have performed.

Defined benefit pensions

A defined benefit pension promises a specific income in retirement. The amount is calculated using a formula based on your salary and your years of service in the scheme. There are two main types:

Final salary schemes base your pension on your salary at or near retirement. For example, if you have an accrual rate of 1/60th and you worked for 30 years with a final salary of £40,000, your annual pension would be 30/60 × £40,000 = £20,000 per year.

Career average schemes base your pension on your average salary over your career rather than your final salary. These have become more common in the public sector in recent years as employers have sought to manage the cost of defined benefit promises.

Defined benefit pensions are generally considered more valuable than defined contribution pensions because they provide a guaranteed income for life, often with inflation protection and a spouse's pension built in. However, they offer less flexibility, you cannot take your money as a lump sum in the same way, and the income is fixed by the scheme's rules.

Steve's observation

If you have a defined benefit pension, particularly a public sector one, it is genuinely one of the most valuable financial assets you can have. The certainty of a guaranteed income for life, often with inflation protection, is something that is very difficult to replicate with a defined contribution pension.

I regularly speak to people who are considering transferring their defined benefit pension to a defined contribution arrangement, often because they have been attracted by the flexibility or a large transfer value. In the vast majority of cases, I would advise against it. The guaranteed income a defined benefit pension provides is extremely hard to give up.

If you are ever approached about transferring a defined benefit pension, please take regulated financial advice first. If the pension is worth more than £30,000, you are legally required to do so.

Which is more common?

Defined benefit pensions are now rare in the private sector. Most private sector employers closed their defined benefit schemes to new members years ago, and many have since closed them to future accrual as well. If you work in the private sector, you almost certainly have a defined contribution pension.

Defined benefit pensions remain common in the public sector. If you work for the NHS, as a teacher, in the civil service, for a local authority or in the armed forces, you are likely to have a defined benefit pension. These are among the most generous pension arrangements available in the UK today.

Transferring between types

It is possible to transfer a defined benefit pension to a defined contribution arrangement, but this is a significant and irreversible decision. If your defined benefit pension is worth more than £30,000, you are legally required to take regulated financial advice from a pension transfer specialist before proceeding.

Transferring from defined contribution to defined contribution, for example, consolidating old workplace pensions, is generally more straightforward. Guide 13 covers pension transfers in detail.

What to do next

Find out which type of pension you have and, if it is a defined benefit pension, what your projected retirement income is. If you have both types from different employers, make a note of each one.

Guide 4 explains how pension contributions work in more detail, including how the qualifying earnings band affects the amount going into your pot.