Pensions: Types of workplace pensions

There are two main types of workplace pensions, defined benefit and defined contribution. You can find out which type of pension you’re paying into by asking HR.

The defined benefit pension is more common for older pension schemes and public sector workers, such as teachers and NHS workers. As we’re all living longer, you won’t normally find this type of pension on offer for new schemes in the private sector. With a defined benefit pension, employees are promised a set annual income at retirement that tends to rise with inflation. The annual pension is typically calculated using a formula that relates to an employee’s final salary and the number of years that they have worked for the company. The employer carries the risk of the investments not performing well enough to deliver the pension. Other calculations may use an average of career earnings rather than final salary.

Defined contribution pensions are much more common and widely used in the private sector. Here, you and your employer pay a fixed percentage of your salary into a pension pot over time. The pot is invested to provide the employee with returns or profit up until they retire. Here you carry the risks of investments not performing well. While all investment carries risk, there are regulatory protections in place for workplace pensions and there are controls in place to minimise the risks. But how your pension is protected and controlled depends on the type of scheme.  Usually, the scheme has trustees in place to protect members’ interests. That’s you, for example, by choosing good investment managers and monitoring their performance. 

On retirement you can access your pot in a number of ways. For example, you can use some or all of the money to buy an annuity. You’ll need to set this up using an insurance company. This is a guaranteed income for life, which pays a regular payment for the rest of your days. For an annuity, you can lock in a certain fixed and stable income for your remaining life. But the rate you get will depend on factors such as interest rates at the time and your health. The risk with an annuity is that you’re taking a bet with the insurer on how long you might live.

When you die, the income usually stops, so if you die before average life expectancy, you may not get as much back in income as you paid out to buy the annuity. But on the flip side, if you live a long time, you could be paid more in income than you paid to buy the annuity. Alternatively, you can keep your pension money invested and take flexible income or lump sums directly as and when you need them. Auto-enrolment legislation means most employers must automatically enrol qualifying employees into a pension scheme. However, employees can opt out.

Most auto-enrolment schemes are defined contribution, where you and your employer both make contributions to the scheme. The rules specify minimum contributions of at least 8% of earnings being paid into the pension. The employer has to pay at least 3%, so the employee must then pay at least 5%, made up of 4% contributions and 1% tax relief to meet the 8% threshold. You might not love the idea of sacrificing your salary now, but it is ultimately a very strong way to build a nest egg for retirement.

Let’s look at an example. If an employee aged 25 earning £25,000 paid in the minimum 8% threshold, they will be making contributions of £2,000 a year to their pension, in equal monthly payments. If this earned investment growth after charges of 5%, then after 30 years, the pension pot could be worth more than £136,000. But the actual contributions made were only £60,000, of which the employee paid only £22,500 and the rest was made by tax relief and employer contributions and investment growth. So that sacrifice of £2,000 per year or £22,500 grew into £136,000. Taking more investment risk can deliver higher amounts of growth. If the investments in the pension grew at 7% a year after charges, then for the same contributions, the pension pot could be worth £196,000 after 30 years.

If you’re not sure which type of pension you have, don’t worry. You can ask your employer or check your payslip and pension statement. The calculations in this video show what happens when you pay into your pension over time. It can be life changing. So when thinking about managing your finances, paying into your pension is one of the most important things you can do.

Related Resources go here…