This page was last updated on 1 November 2020.
What is a defined contribution pension scheme?
Defined contribution pensions schemes might sound complicated, but they’re simple really.
You pay in a small amount of your income each year. Income tax is not charged on this amount, meaning you benefit from tax relief. Your employer often matches your pension contributions if you are in a company scheme.
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If you are in a salary sacrifice scheme, you may also benefit from a slightly higher level of take home pay as what you pay in national insurance is reduced.
It depends on what type of defined contribution pension you have, but usually your pension pot is invested. This process is managed either by you, your Trustees or by your employer, as, due to pension auto-enrolment, they choose the default pension investment options. When you retire, you start receiving pension benefits.
In this article, we will take you through the differences between these and defined benefit pensions.
We will also discuss the rules for withdrawing from your pension pot, as well as money purchase schemes and your alternative options.
Finally, we will review the advantages and costs of defined contribution pension schemes.
Here is a video that explains how a DC scheme works.
What is the difference between a defined benefit and a defined contribution pension plan?
Defined benefit pensions may sound similar to defined contribution schemes, but there are a number of key differences.
Defined contribution vs defined benefit- how much will I receive in pension income?
A defined benefit plan calculates the amount you will receive. Final salary pension schemes pay you a percentage of the final salary you earned at the end of your career.
As well as final salary schemes, there are career average schemes.
Career average schemes pay you an average rate, which is calculated based on your earnings over time.
Both final salary and career average schemes are types of defined benefit pension.
If you have a defined contribution scheme, you are responsible for the amount you will end up living on. You have responsibility for how much you put into your pension pot, and your retirement benefits vary accordingly.
How much control do I have over where my pension is invested?
With a defined contribution pension, you can often control where your money is invested. Some of these pensions, such as SIPP accounts, give you full control. If your pension gives you full control over how your money is invested but you are unsure how to manage it, consider consulting an independent financial adviser.
How about a cash balance pension scheme?
A cash balance pension is sort of like a combination of the two. It blends features of both. Like a defined contribution pension, you pay in a portion of your salary, and your company pays in too. As with a defined contribution pension, your contributions are tax-free.
But like a defined benefit pension, you are guaranteed a certain amount by the pension provider when you ultimately retire. The pension provider has a team of investment managers to earn a return. They put your money to work by investing in shares and other assets.
But if their investments underperform, you still get the same pension payments. So a cash balance scheme combines elements of both the main types of pension.
Is a defined contribution pension the same thing as a money purchase scheme?
In short, yes. With a money purchase scheme, your retirement income is determined by the amount of pension contributions you’ve made, as well as a few other factors. The following are some examples of other factors affecting your retirement income: employer contributions, service charges made by your pension provider, and investment performance.
So a money purchase pension is the same as a defined contribution one. Both are defined by how they differ from defined benefit pensions. The difference is that with a defined benefit pension, retirement income is primarily determined by your salary.
Where is the money in my pension pot invested?
When you contribute money, experts invest it to earn a return and try to maintain its value against inflation. Alternatively, you will have the responsibility to invest the capital yourself. This is the case if you have a SIPP.
In practice, there is often a degree of variation. Sometimes your money will be managed exclusively by a pension specialist or a board of trustees. Sometimes you will be able to choose where it is invested, but you will be provided with support and guidance.
Ask your employer what level of control you have, as it depends on what specific form of contribution pension you have.
Do defined contribution plans come with tax benefits?
Your contributions are deducted from your effective salary for income tax purposes. You also get tax relief on your pension contributions.
If you are a higher rate taxpayer, you in effect get a 40% bonus on your pension contributions! This significantly lowers the cost of saving for retirement.
Can you take money out of a defined contribution pension plan?
You can take money out of your pension, either in the form of regular payments or in a lump sum. If you are not sure which is right for you, consider seeking financial advice from an expert in the pensions sector.
What about withdrawing a lump sum?
You might want to take a lump sum out of your pension to purchase an annuity, from an insurance company to pay off debt, or make a high-value purchase.
For example, many expats cash in all or part of their pension pot to buy a property abroad. Others use the money to pay off mortgage debts.
You can take out up to a quarter (25%) of your retirement savings tax-free. Pension withdrawals over this margin will incur income tax. So the tax relief on lump sum withdrawals can represent a big saving, especially if you are in a higher tax bracket.
Withdrawing from your pension is a risky business. Whether you intend to buy a property or make an investment, do your research. Losing a chunk of your pension can be a real disaster, especially if you depend on that money to maintain your present lifestyle.
When can I start withdrawing from my pension?
Changes were made to the UK pension system in April 2015. The current minimum retirement age for defined contribution participants is 55. Individuals can choose when to start withdrawing money from their pension.
Can I transfer defined contribution pension plans to a new employer?
Transferring some pensions can be a real pain. You can transfer these pensions between employers, but it may not be easy. There is no simple guide to transferring pensions, as it varies between different plans. Consult your pension provider if you are changing employment and want to transfer pensions.
Is it worth signing up for a company pension?
Enrolment in employer retirement plans has a number of benefits. The main benefit is that employers usually make contributions to a retirement fund on behalf of their employees.
The pension details vary between companies, but employee contributions are often matched. When you and your employer are both contributing funds to your workplace pension, its value increases a lot faster.
What are the alternative options?
Though there are a number of benefits to contribution schemes, it’s worth considering your alternative choices.
A defined benefit pension is the obvious alternative, but whether this is an option for you is down to your employer. If your employer doesn’t offer a defined benefit pension, it isn’t really a possibility for you.
If you fancy having even more control over your money, a SIPP might be the right choice for you. SIPPs are defined contribution pensions, but might not be the same as what your employer offers. With a SIPP, you have complete autonomy to make your own investments in the stock market.
Investing in stocks represents a risk and the performance of your assets is uncertain. Their value can go down and you won’t be able to claim compensation. If stocks aren’t for you, there are a range of pension pot options when you have a SIPP. So if you fancy managing your own retirement savings, a SIPP pension fund might be the option for you.
Should I purchase an annuity with a lump sum from my pension?
Alternatively, you could consider purchasing an annuity. You can purchase an annuity with a cash lump sum, and you are paid a percentage of that sum for a long period. There are different types of annuity.
The main upside of annuities is the guaranteed income they provide. But you lack control of the money. You cannot change how much you receive at your own discretion. Many find the investment returns of annuities disappointing.
Am I still eligible for state pensions?
Regardless of your other pension income, you are automatically eligible for a state pension, if you have paid the sufficient amount of national insurance contributions.
The government makes these payments to all UK pensioners, whatever the state of their personal finances.
But the monthly payment is quite small. Especially if you earn a high salary, adjusting to a state pension could be an unwelcome experience.
What are the most attractive features of defined contribution pensions?
There are a number of upsides to a defined pension contribution.
- You can vary how much you pay into your pension. So depending on what lifestyle you are planning on, you can pay more or less into your pension pot.
- The tax benefits of paying into your pension are substantial. But these benefits are much the same as those attached to other pensions.
- You can often control where your pension is invested.
- The retirement date attached to these pensions is relatively early. With other schemes, you can only withdraw when the scheme rules allow. Flexibility is always worth having, even if you don’t currently intend to withdraw from your pension any time soon.
- Many of these pensions have favourable terms in the event of your death. While it’s not a jolly thought, it is best to ensure your loved ones will be provided for. If a member passes away, these schemes generally pay out the entirety of their pension pot in accordance with their wishes.
What are the potential costs of a defined contribution pension?
Despite their benefits, defined contribution pensions aren’t right for everyone.
- Many workplaces shift the burden of responsibility onto the individual employee. You may be perfectly ready to assume this responsibility yourself. But if you prefer to focus on other things and let others handle your finances, this is not the ideal pension for you.
- Contribution plans sometimes feature lower employer contributions than traditional pensions. But this is not a hard and fast rule.
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