Pensions: defined benefit vs. defined contribution
Which pension type is best to achieve your retirement goals? Broadly speaking, there are two main types of pension schemes: defined contribution and defined benefit. How do they work, exactly? Is one superior to the other, and how can they be integrated into a retirement plan?
Below, our Gratham financial advisers explain the main differences between these two types of pension, how they compare in 2024-25, and why financial advice can help you decide on the best option for your unique financial situation and goals.
An overview of the two pensions
Before we explain how defined contribution and defined benefit pensions work, we need to clarify that these are both different from the State Pension.
The latter is provided to individuals who claim it after reaching their State Pension age (currently 66). An individual needs 35 “qualifying years” on their National Insurance (NI) record to get the full new State Pension. At least 10 years are required to get any income at all.
As such, defined contribution and defined benefit pensions can provide separate incomes to the State Pension. Quite often, they can work together to support someone’s retirement lifestyle.
A defined contribution pension is often called a pension “pot”. Like a savings account, you add to it over time – with some key differences. For instance, the money is not usually held in cash but in investments like equities and bonds.
Also, defined contribution pensions have special rules – e.g. tax relief on the scheme member’s contributions (explained below) and a Normal Minimum Pension Age (NMPA) governing how early the funds can be accessed.
By contrast, a defined benefit pension has no “pot” of money from which the individual can draw. Rather, a former employer typically promises to pay them a guaranteed income in retirement. This type of scheme is more common in public services, such as police and teacher pensions.
Comparing defined contribution and defined benefit pensions
Both types of pension are similar in that they normally cannot be accessed until later in life (e.g. after 55). However, they operate very differently.
Defined contribution pensions are similar to owning an investment account – with special rules. The value of the “pot” will likely fluctuate over time as markets change.
By contrast, a defined benefit pension (sometimes called “final salary” pension) is typically underwritten by the UK taxpayer. The former employer is responsible for ensuring the promised retirement income is delivered, making up for shortfalls in underlying investments.
A defined contribution pension offers a high degree of flexibility. Under “flexi-access” rules, for instance, the member can withdraw more or less according to their needs and the conditions of the market. They can also invest in a wide range of assets and markets.
However, the investment risk may weigh more heavily on this individual. They need to ensure their withdrawals are sustainable. Taking too much money out too quickly could result in a lower income later – or depleted funds, in a worst-case scenario.
Which pension is “better”?
Defined benefit pensions are often called “gold-plated” pensions due to their rare and generous benefits. These are difficult – if not impossible – to replicate elsewhere.
In particular, these pensions typically offer an income which lasts until the former employee’s death. When combined with the indefinite nature of the State Pension’s income, this can offer people a high degree of financial stability and predictability in retirement.
Moreover, defined benefit pension income also tends to rise with inflation. This helps to keep the individual’s spending power consistent over time.
These benefits can be replicated – to a degree – with a defined contribution pension. Specifically, if pension funds are used to purchase an annuity; a financial product which provides a steady income in retirement. However, the income will likely be lower than a defined benefit pension.
However, a defined contribution pension can offer unique advantages, making them more attractive to certain clients.
In particular, many employers are very generous with their own contributions to their employees’ pension pots. By law, they are required to contribute at least 3%. However, some organisations go far higher – perhaps even offering a “matching scheme” which could build your pot faster.
Another advantage is that unused funds in a defined contribution pension can be inherited by the loved ones of the former owner. This cannot be done with a defined benefit pension (although limited benefits may remain for a surviving spouse or certain dependents).
Before the 2024 Autumn Statement, unused pension funds could be passed down without IHT (inheritance tax). However, from April 2027, these may be included in the value of an estate for IHT purposes. Please seek financial advice if you believe you may be affected.
Final thoughts
In 2025, it is still fair to say that defined benefit pensions are typically regarded as “superior” to defined contribution pensions.
This is partly why the FCA (Financial Conduct Authority) urges financial advice if someone is considering a pension transfer out of a defined benefit scheme worth over £30,000.
However, a defined contribution pension is still a very powerful tool in many clients’ retirement plans. They offer unique tax benefits (e.g. tax relief) which can enhance the “saving power” of your contributions, and the ability to pass down unused funds upon death is often greatly valued by many clients who want to leave a meaningul legacy to their loved ones.
If you’d like to make sure you’re taking the right steps to safeguard your financial future, please get in touch.
