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Are you the sort of person who’s clued up about your future pension income – or do you simply know that you’ve been paying into a pension and that’s about it? You might have several pensions from across your working life. And if you’re not sure how they actually work, you’re not alone.
But it’s worth getting clued up. Understanding your pensions can help you plan for how much money you’ll have to live on, as well as how you access the money, how it’s taxed, and what happens when you die.
We’ll explain the key differences between the two main types of private pension: defined benefit (DB) and defined contribution (DC).
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Nearly all pensions fall into one of two main categories: defined contribution (DC) or defined benefit (DB). It’s important to understand which you have.
Zoe Alexander, director of policy and advocacy at Pensions UK, says: “Your pensions are likely to be one of your biggest financial assets at retirement. As you get closer to your final days of working, it’s vital to know what you have, how they work, and what choices you’ll need to make.
“If you don’t understand them properly, you might underestimate what you’ll get or overestimate it and risk running out of money.”
If you’re not sure which type you have, don’t worry. Your annual pension statements will contain the details. The language used will often provide a clue.
You most likely have a DB pension if your paperwork mentions any of these:
If you work in the public sector, including in the NHS, teaching or civil service, you are likely to have a defined benefit scheme.
You most likely have a DC pension if you hear or see these terms:
Most modern workplace pensions set up in the private sector, particularly since 2012, are DC schemes. According to The Pensions Regulator, only 4% of the remaining 5,000 private sector DB schemes are now open to new members.
But you might have a DB pension from a job you did earlier in your career, or if you’ve worked for the same place for a long time and retained your right to a final salary pension.
If you have set up a personal pension for yourself, such as a SIPP, it is a DC scheme.
How to check if you’re still not sure:
Think of a defined contribution pension as a pot of money with your name on it. The money you and your employer pay in is invested, and the value of your pot can go up or down depending on how the investments perform. The amount you eventually get in retirement depends on how much was paid in and the growth achieved.
Think of a defined pension as a promise from an employer. It guarantees to pay you a specific, pre-determined income for the rest of your life from a set retirement age. This income isn’t based on a personal pot of money, but on a formula that usually considers your salary and how long you worked for the organisation.
Matt Conradi, deputy CEO at Netwealth, sums up the main differences: “DB pensions provide an income for life. The amount is typically based on your years of service and salary, often with increases each year that are linked to inflation. “The key benefit is security: your income is guaranteed and doesn’t depend on investment performance or how long you live.
“DC pensions, by contrast, depend on how much you and your employer have paid in – and how well your investments have performed. You choose how and when to draw income, making them more flexible and potentially more tax-efficient.”
You don’t get this flexibility with DB pensions, where the scheme rules determine how and when income is paid (generally in regular monthly instalments). But they are usually more generous. This, and the certainty of what you’ll get, is why final-salary schemes are often referred to as ‘gold-plated’. That’s also why you should never transfer out of a defined benefit scheme without taking financial advice (and this is compulsory if the defined benefit scheme is worth more than £30,000 in total).
The biggest difference between DB and DC pensions is around how much you get when you retire.
Alistair Russell-Smith, head of the corporate advisory practice at Spence & Partners, a pension consultancy, explains: “DB pensions provide a defined level of benefit, linked to your earnings and pensionable service.
“A typical example historically was a pension of 1/60th of your final salary for each year of service. This provided a pension of two-thirds of final salary at retirement for someone working for 40 years.”
Career average pensions usually pay less, as they are based on an average of your salary from when you joined the scheme until you leave or retire. The local government pension scheme, for example, provides a pension of 1/49ths of your average salary per year of service.
With a DC pension, there are no such guarantees: the value of your pot depends entirely on the contributions made by you and the employer and your investment gains. The more you pay in and the better your investments perform, the bigger the pot you will retire with.
With DB pensions, it’s fairly straightforward. You usually start receiving the income as monthly payments when you reach state pension age. The payments normally increase each year in line with inflation. Depending on your scheme, you may be able to retire early, usually in return for a reduced income.
The pension income is paid until you die, so you don’t need to worry about running out of money or the payments suddenly stopping. One drawback is that it’s not possible to change the payments.
There are more options with DC pots, which you can typically access from age 55 (rising to 57 in 2028). Royal London’s pensions and tax expert Clare Moffat explains: “You normally have the choice of taking money out of your pension as one or a series of cash lump sums, where some of it is tax-free.
“Or, you could move it into drawdown where the money is still invested, and take some tax-free cash. You can take as little or as much as you want at a time, which can be useful to make sure you stay within the basic-rate tax band.
“The third option is buying an annuity, which would give you a regular, guaranteed income until your death and, if you pay extra, the death of a husband, wife or civil partner.”
Alistair Russell-Smith, head of the corporate advisory practice at Spence & Partners, a pension consultancy, adds that while DB pensions are generally perceived as better – largely because of the certainty of retirement income – the downside is they lack flexibility.
“DC allows you to phase your retirement income to meet your needs. For example, you might want to draw a larger income earlier in retirement whilst you’re more active,” he notes.
You can also combine different options, for example using part of the pot to buy an annuity for core costs and leaving the rest in drawdown for flexibility.
DB and DC pensions are both subject to income tax when you take benefits in retirement.
Any income you receive from these pensions is added to other income, such as the state pension, part-time earnings, savings or rental income, to work out whether tax is due. If your income for the tax year is less than £12,570, you don’t have to pay income tax. Anything above this and you may have to pay 20%, 40% or 45% tax depending on your total income.
However, both types of pension will also let you take 25% tax-free. With a DC pension, it’s possible to take this money as a tax-free lump sum, when you either move funds into drawdown or buy an annuity (referred to as ‘crystallising’ your pension).
So, for example, if you crystallised £100,000, you could get £25,000 as a tax-free lump sum and £75,000 to buy an annuity or go into drawdown, which would be subject to tax. (If you made a straight withdrawal without crystallising any of your pension, only the first 25% would be paid tax-free and the remainder would be taxed at your highest rate).
However, with a DB scheme, it’s a bit more complicated. The 25% tax-free cash rules still apply, but the calculations will be different and you might find that the amount you’re able to take is restricted to a degree by the rules of your scheme.
Some schemes (normally public sector) will pay a tax-free lump sum that is paid in addition to your income. Others will give you the opportunity to take a tax-free lump sum in exchange for a reduction to your pension income – for example £15 of tax-free cash for every £1 of income.
This is called ‘commuting’. Where schemes pay a separate lump sum, you may also be able to commute some of your pension income, if the scheme rules allow this, to ensure you get your full 25% entitlement paid tax-free.
If you die and you have a DB pension, a surviving spouse, partner, child under 23 or other financial dependant, will normally receive a percentage (often 50%) of your pension until they die. Eligibility will be decided by the pension scheme rules. You can also nominate who you want to receive a lump sum death in service benefit if you die before retirement age.
If you’re single and don’t have financial dependants, no one will receive an income from your DB pension when you die.
The rules around death benefits from DB pensions are complicated and can depend on the scheme. Moffat points out: “It’s a little-known fact that there are some DB pensions, such as the police and armed forces, where if a husband or wife remarries, they lose that entitlement to the dependant’s pension.”
Any DB pension income paid on death is subject to the beneficiary’s highest income tax rate.
DB lump sum death benefits are tax-free if you die below age 75 – assuming that the lump sum is within the lump sum and death benefits allowance and it is paid within two years of the scheme administrator becoming aware of your death.
In terms of DC pensions, if you have money left in your pot when you die you can leave it to anyone you want (you can nominate a beneficiary by filling out a form from the pension provider).
Conradi says that people often assume DB pensions are superior, but there are scenarios where DC pensions have the upper hand, particularly when it comes to passing money on. He explains: “If you die before age 75, your DC pension can be passed to beneficiaries completely tax-free.
“If you die after 75, beneficiaries will pay their marginal rate of income tax on any withdrawals, though the fund can continue to grow tax-free while untouched.”
But these tax-free benefits will reduce from April 2027, since pensions will become liable for inheritance tax, if the total estate (including pension) is over the IHT threshold.
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