Pensions are something that almost everybody will have to think about. Few people will be wealthy enough to disregard the need for a continued income after they stop working. Research has found that the average income that a person needs to be able to enjoy a retirement free of money worries is quite high.
It sets the current total at £33,000 a year for a single person, and £47,500 a year for a couple. Therefore, most people look to supplement their state pension with a personal one. There are two kinds of personal pension: a defined contribution one and a defined benefit one. In this article we will look at the differences between them so that you can decide which will be the most suitable for you.
The first thing to note is that there are similarities between the two pension types. Both a defined contribution and a defined benefit pension are forms of pension plan that are usually set up by your employer. However, beyond that, the two types of plan that function in distinctly different ways. Let’s have a look at each of them in turn.
What is a defined contribution pension plan?
This type of pension can either be one that is set up by your employer, which would classify it as a ‘workplace’ pension, or one that you set up yourself, classifying it as a ‘private pension’. That latter choice is most often made by people who are working but who do not have an employer that can create a pension scheme for them; e.g. those who are self-employed.
The money that you (and your employer if it is a workplace one) pay into a defined contribution pension plan is then invested. Typical investments that will be made using your pension contributions are in shares, but it means that the size of your pension will be determined by how well the chosen investments do. Under a defined contribution pension plan, it can rise or slump at various points during your working life as the value of the shares, stocks or other investments go up and down. Sometimes your total contribution over the years is reinvested in lower risk options as you draw nearer to retirement, to reduce any dangers of the value decreasing.
What is it worth?
The final value of your defined contribution pension will be determined by several factors:
- How much you have paid in over the years
- The performance of the investments
- How you choose to get paid (e.g. in smaller regular amounts or as a lump sum)
The UK tax system allows for 25% of the value of a pension to be free from tax, but the provider of a defined contribution pension scheme will usually claim a minor amount in management fees.
What is a defined benefit pension plan?
A defined benefit pension plan is a much simpler kind of pension. It always takes the form of a workplace one set up by your employer and other common names for it are a ‘career average’ plan or a ‘final salary’ one. That is because either the career average earnings or final salary of the employee is one of the things used to determine the size of their eventual pension pot.
The total payment is decided by three factors:
- Your final salary or average earnings
- The number of years you have worked for the company
- The rate at which the pension lump sum has risen
Again, up to 25% of its value can be exempted from taxation.
What is the key difference?
The main difference between a defined contribution plan and a defined benefit one is that you will have less control over the final value of the former. Because it involves investing your financial contributions in assets such as bonds, shares or stocks, it means that the total amount that you will have to retire on is heavily dependent upon their performance. By contrast, with a defined benefit pension scheme, you can have greater control over the final sum by sticking with a company and progressing your career and earnings with them.
That is the reason why many people prefer to pay into a defined benefit pension plan. They are widely regarded as the best types of personal pensions, because there is less risk and the final sum is usually greater – particularly for people who stay with one company. Unfortunately, they are also now much less common. That is because they are expensive for employers to maintain, so increasingly defined benefit pension plans are only available to public sector workers or those employed by big companies.
These are the basic differences between the two types of plan. Speak to specialists in retirement planning from Shropshire or anywhere else for more detailed information.
