Transparent, trustworthy advice - Start your financial planning journey 🚀
Blog > Pension Advice > What are the different types of pensions and how do they work?

What are the different types of pensions and how do they work?

10 minute read

Learn what the differences are and what this means for your money.

Table of Contents

What are the different types of pensions and how do they work?

When planning for your financial future, pensions remain a cornerstone of retirement savings strategies. But with different types of pensions available, understanding the nuances is key to making them work for you. 

In this article, we’ll explore both defined contribution and defined benefit pensions, how they each work, and outline their distinct features to help you make informed decisions for your long-term financial well-being.

What are defined contribution pensions?

Defined contribution pensions are like personal savings pots for retirement, growing over your career and offering flexibility and control over your retirement savings. These plans are based on the contributions you and your employer make, which are invested in a selection of funds. The total pension value at your retirement depends on these contributions and how the investment performs. 

In a defined contribution plan, you’re essentially building a nest egg for your future self. The more you contribute, the larger your pension pot will be. You also have a say in how your investments are managed, allowing you to tailor your portfolio to your risk appetite and financial goals.

Example:

Imagine you’re a 30-year-old earning £50,000 annually. You contribute 5% of your salary to your defined contribution pension, and your employer matches your contributions pound for pound. Over 30 years, assuming an average annual investment return of 5%, your pension pot could grow to a substantial £250,000.

Here’s a more detailed look at how they work:

Contribution mechanism

You contribute a portion of your salary to the pension, as does your employer. Your employer must automatically enrol you into a pension scheme and make contributions to your pension if you’re eligible for automatic enrolment. These contributions are typically set as a percentage of your salary. The total pension pot builds up over time based on these contributions.

Contributions to defined contribution pensions receive tax relief. This means money invested in your pension is taken from your salary before income tax is applied, effectively reducing your tax bill.

Investment growth

Your combined contributions are invested in a range of assets, such as stocks, bonds, and property. You often have a choice of funds in which to invest, allowing you to tailor your investments to your risk tolerance and investment horizon.

Do bear in mind though, like any investment, the value of your pension pot can go up or down depending on how these investments perform. This means that the final value of your pension is not guaranteed and can vary.

Flexibility and control

You have the flexibility to change your contribution levels and can typically choose to contribute more to increase your potential retirement pot. Most schemes also offer a range of investment options, from conservative to more aggressive strategies, allowing you to adjust your investment approach according to your age, risk tolerance, and financial goals.

Retirement options

When you actually retire, with a defined contribution pension, you have several options for how you’d like to access your pension pot. You can usually take up to 25% as a tax-free lump sum, with the rest being used to provide a retirement income, which might be through an annuity, drawdown, or a combination of both – you’ll pay tax on this remaining 75%.

Risks and considerations

The investment risk with a defined contribution pot lies with you. This means they’ll require more active management and engagement from you, especially in terms of investment choices and monitoring performance. 

Poor investment performance can affect the size of your final pension pot. 

Portability

One of the main benefits of defined contribution pensions is they can be portable between jobs. This means if you change employers, you can usually continue contributing to the same pension or transfer the value of your existing pot to your new employer’s scheme.

What are defined benefit pensions?

Defined benefit pensions, also known as final salary pensions, are a type of retirement plan that promises a specific income upon retirement, based on your salary and length of service with your employer. This traditional form of pension is often considered more predictable and stable compared to defined contribution pensions. 

Defined benefit pensions were once more common in the private sector, but they’ve become increasingly rare due to their high costs for employers. However, they remain prevalent in the public sector for roles in government, education, and healthcare.

Some key aspects of defined benefit pensions include:

Income calculation

The income you receive from a defined benefit pension is calculated using a formula set by the pension plan. This formula typically considers factors such as your salary (either the final salary or an average over a period) and your years of service with your employer.

For example, a common formula might be 1/60th of your final salary for each year of service. So, if you have 30 years of service and your final salary is £60,000, you would receive £30,000 per year in retirement, every year until you pass.

Some defined benefit pensions are based on your average earnings throughout your career, e.g. Career Average Revalued Earnings (CARE). This means each year, a portion of your salary is earmarked for your pension, and the total of these amounts, often revalued to keep up with inflation, determines your pension income.

Employer’s commitment

In defined benefit pension plans, your employer commits to paying you a certain amount during your retirement. They’re responsible for ensuring there are enough funds in the pension to meet these obligations.

This means the investment risk lies with your employer. Market fluctuations and investment performance do not directly impact the income you receive in retirement, as they would with a defined contribution pension.

Benefits and security

The main benefit of a defined benefit pension is the guarantee of a specific income in retirement, which is unaffected by the stock market or economic downturns. Once you start receiving benefits, the amount is fixed. Many defined benefit pensions are index-linked, meaning they increase each year in line with inflation, helping to preserve your purchasing power in retirement, offering protection against the cost of living increases.

Many of these plans also provide benefits to your spouse or other beneficiaries in the event of your death, ensuring financial security for your loved ones, even after you’ve gone.

Funding and management

These pensions are funded by contributions from both your employer and often you, the employee. The exact contribution rates can vary between different schemes.

The pension fund is typically managed by your employer or a pension fund manager appointed by your employer. They’re responsible for investing the fund’s assets to ensure there is enough money to pay out pensions to all members upon retirement.

If necessary, the Pension Protection Fund (a public corporation of the Department for Work and Pensions) offers a safety net for defined benefit pension schemes of insolvent employers, providing certain levels of compensation to members of eligible defined benefit pension schemes if the employer can no longer fulfil its pension obligations.

Want to talk about your pension?

Key differences between defined contribution and defined benefit pensions

Understanding the differences between defined contribution and defined benefit pensions is crucial for making informed choices about your retirement planning. 

Here’s a breakdown of the key contrasts:

Risk and responsibility

In a defined contribution pension, you, the employee, bear the investment risk. The value of your pension at retirement is directly linked to the performance of the funds you’ve invested in. This means if the investments do well, your pension pot grows, but if they perform poorly, your pension value could decrease. You also have the responsibility of deciding how much to contribute regularly, which directly impacts the size of your pension pot.

In a defined benefit pension, on the other hand, the investment risk is borne by your employer. Your pension is calculated based on your salary and length of service, ensuring a pre-determined and stable income after retirement, regardless of market fluctuations. This predictability takes away the stress of monitoring investment performance and provides a secure financial future. 

Pension value

The value of your defined contribution pension pot will depend on how much you and your employer contribute, as well as the performance of your investments. As mentioned above, this can lead to variability in your pension income. For example, if you retire during a market downturn, your pension pot may be worth less than you had hoped.

In contrast, the value of your defined benefit pension income is predetermined by a set formula, usually based on your years of service and salary, providing a predictable and stable income that doesn’t depend on investment returns or market conditions.

Control and flexibility

In a defined contribution pension, you have a greater degree of control and flexibility. You can choose where your pension contributions are invested and change these investments over time. This allows you to tailor your pension strategy to your personal risk tolerance and financial goals. Additionally, you can decide how much to contribute within certain limits, which can be adjusted as your financial situation changes.

In a defined benefit pension, you have less control over how the pension funds are invested and how much you contribute. The employer sets the contribution levels and investment strategies. While this means less flexibility for you, it also removes the burden of making complex investment decisions and provides a clear, defined benefit upon retirement.

Advantages and disadvantages of defined contribution and defined benefit pensions

Each pension type comes with its own set of benefits and challenges. It’s crucial to understand these to align your pension choice with your financial goals and lifestyle.

AdvantagesDisadvantages
Defined contribution pensionsFlexibility: You’re in control of how much you contribute and can adjust these amounts as your career progresses or personal circumstances change. This flexibility extends to investment choices, allowing you to switch between funds based on your risk appetite and market conditions.Investment risk: The value of your pension can fluctuate with market conditions, making your retirement income uncertain. It requires a level of financial literacy to manage these risks effectively.
Potentially higher returns: These pensions are investment-linked, meaning they offer the potential for higher growth, especially if you’re savvy with your investment choices and the market performs well.Complexity: Actively managing your pension requires ongoing engagement and understanding of financial markets. This can be daunting for those not financially inclined, often necessitating advice from financial experts.
Portability: These plans are typically easier to transfer if you change jobs. This is particularly beneficial in today’s dynamic job market, where career changes are common.Dependency on contributions: Your final pension amount depends heavily on how much and how long you contribute. Career breaks or reduced contributions can significantly impact the final value.
Defined benefits pensionsPredictability: You’re guaranteed income post-retirement, calculated based on your salary and years of service. This financial security is reassuring, especially in volatile economic times.Less control: You have little to no control over how the pension funds are invested, which could be a drawback if you prefer having a say in your investment strategy
Lower personal risk: The investment risk lies with your employer, not you. This means your retirement income is less affected by market fluctuations, providing a stable financial foundation for your retirement years.Inflexibility in contributions: You generally can’t adjust your contribution levels. This can be limiting, especially if your financial situation changes.
Simplicity: Once you’re enrolled in a defined benefit plan, there’s minimal requirement for active management or decision-making from your end, making it a hassle-free option.Sensitivity to employer health: The security of your pension can be tied to your employer’s financial health. If your employer faces financial difficulties or goes bankrupt, it could impact your pension’s stability.

Making an informed decision

Choosing the right pension plan is a significant financial decision, one that requires you to consider your individual circumstances, risk tolerance, and your long-term financial objectives. While this article provides a foundational understanding, everyone’s situation is unique. Consulting with a financial adviser can provide valuable guidance, help you navigate the complex world of pensions, and offer personalised guidance tailored to your specific circumstances.

At TheWealthPoint, we can assess your financial goals, risk appetite, and current pension arrangements to recommend the most suitable option for your needs. Remember, your pension is an investment in your future, and making informed decisions today will lay the foundation for a comfortable and secure retirement.

Got some questions about
your pensions and investments?

Related Posts

13 Mar

Pensions and divorce

10 minute read

Pensions and divorce: what you need to know Pensions are often an overlooked part of the settlement process during a divorce. Yet it is something that you and your partner should be actively discussing in order to ensure that both parties are fairly […]

FAQs

Will my State Pension be reduced if I have a private pension?

Your State Pension will not be reduced if you have a private pension. They are entirely separate; your private pensions are made up of your contributions (and your employer’s if its a workplace pension). Your State Pension is based on your National Insurance contributions.

Is it better to take a lump sum or monthly payments?

Whether or not taking a lump sum or monthly payments will be the better option depends entirely on you and your individual circumstances. A lump sum may be something to utilise if you expect to have a shorter life expectancy. Monthly payments can be beneficial if you want to spread your income across a period of time, its suitable if you would like a regular monthly income.

Why can’t I cash in my defined benefit pension?

You can access your defined benefit pension but this means you will have to begin taking income immediately. It’s not ideal for a lot of people as they tend to want flexible access to tax-free cash and lump sums if needed. Defined benefit pensions do have the advantage of providing security in terms of a guaranteed retirement income but their structures are quite rigid; you can’t decide to take less or more money if your circumstances change, your income is fixed.


Our Services

Discover more of our financial planning services to help you create a successful future and achieve your goals.