What is the difference between a defined benefit and a defined contribution pension?

Full answer

Defined benefit and defined contribution pensions are structured in fundamentally different ways, and the difference has huge implications for retirement planning. A defined benefit pension, sometimes called a final salary or career average scheme, promises to pay a specific, formula-based income in retirement, usually calculated from a fraction of your salary (either your final salary or an average across your career, revalued for inflation) multiplied by your number of years of pensionable service. The employer (or, for public sector schemes, the government or a funded scheme) bears all the investment risk, meaning the promised income is paid regardless of how the underlying pension fund's investments actually perform, and it is usually index-linked and continues to pay a reduced pension to a surviving spouse. Defined benefit schemes have become rare in the private sector, mostly closed to new members or new accrual, but remain common in parts of the public sector, such as the NHS Pension Scheme, Teachers' Pension Scheme, and Local Government Pension Scheme. A defined contribution pension, the far more common type today, works completely differently: you (and usually your employer) pay money into an individual pot, which is invested in funds you (or a default fund manager) choose, and the eventual retirement income depends entirely on how much was paid in, how long it was invested, investment performance, and charges deducted along the way -- all of the investment and longevity risk sits with the individual, not the employer. Someone moving from a defined benefit scheme to a defined contribution scheme should think very carefully, and usually take regulated financial advice, since transferring a defined benefit pension gives up a valuable guarantee that is often extremely expensive to replace.