Defined contribution pension schemes

If you’ve recently joined a new employer’s pension scheme, chances are it’s a defined contribution scheme. And if you have a personal pension, it definitely is. Unlike defined benefit pensions, which guarantee a certain level of income for life, the ultimate value of defined contribution pension schemes is based on the performance of investments held. While they’re not such a sure thing as defined benefit pensions, they’re still a good way to save for retirement, thanks to a combination of tax breaks and, often, employer contributions. Read on to find out why it’s usually well worth opening a defined contribution pension.

What is a defined contribution pension scheme?

A defined contribution pension scheme is a type of pension where you know the amount being paid in – hence your contribution being “defined”. But the amount you’ll have built up when you retire will depend on the performance of your pension investments. This type of pension is also known as a “money purchase” scheme. Defined contribution schemes are different from defined benefit schemes, which promise a certain level of regular income.

How do defined contribution pension schemes work?

With defined contribution pensions, the money you pay into the scheme over time is invested. The idea is that the value of your investments will grow so that ultimately the amount in your pension (known as your pension pot) will be enough to provide a decent retirement income.

Most people make regular payments into their defined contribution pension. If you have a workplace pension, there will be a minimum amount set by your employer. You may also be able to make additional payments above this, either on a regular or ad hoc basis. Your employer will almost always contribute to your pension as well.

If you have a personal defined contribution pension, you can also choose to pay in a regular amount. You may also be able to contribute on a less regular basis. This approach can be useful for self-employed people with a less consistent income.

When you retire, you can start taking out the money in a defined contribution pot. Money can usually be taken either as lump sums or a regular income.

What other types of pension are there?

There are 2 other main types of pension.

• The state pension. This is the pension you’ll receive from the UK government when you reach official retirement age. You don’t make direct payments into the state pension. Instead, your eligibility to receive a regular state pension income is based on your National Insurance contributions.
• A defined benefit pension. This is a type of workplace pension scheme offered by some employers. These pay out a fixed, regular income when you retire, based on a percentage of your salary. The amount also depends on how long you worked for the company. Defined benefit pension schemes are less common than they used to be.

Can I take out a personal defined contribution pension?

Yes. All personal (or private) pensions – pensions that you open yourself, without any input from your employer – will be defined contribution pensions. If you want, you can open a personal pension in addition to your workplace scheme.

There are a few different types of personal pension:

• Standard personal pensions. With these schemes, you can usually choose the broad investment strategy for your pension pot (for example the level of risk you want your money to be exposed to). However, you don’t directly manage your investments. Instead, they are managed by the pension provider in accordance with the strategy you’ve agreed to.
• Stakeholder pensions. These are similar to standard pensions, but there are strict government rules about how they’re managed. Charges are capped (though they’re not always the lowest available), they allow low minimum contributions, and you can stop and start payments and transfer out without incurring fees. Investment options can be more limited.
• Self-invested personal pensions (SIPPs). With a SIPP, you are responsible for choosing and managing your investments. There’s typically a wider and more sophisticated range of investment options than other personal pensions. There may be higher investment charges in exchange for this choice. SIPPs tend to be better for more experienced investors that make larger contributions and/or have a larger pot.

How much do I need to pay into a defined contribution pension scheme?

If you’re paying into a personal pension scheme, there are often no lower or upper limits on how much you can, or need to, pay in. That said, always check the terms of each specific scheme in case they have minimum or maximum contribution levels.

If you’re paying into a workplace pension, your minimum contribution will be set by your employer as a percentage of your salary. If you’ve been automatically enrolled into your workplace pension, this minimum contribution will usually be dictated by the terms of the government’s auto-enrolment scheme. This is an initiative whereby all employees are enrolled into a workplace pension when they start a job unless they opt out.

Under the auto-enrolment scheme, the minimum percentage of salary that must typically be paid by employees has been set at 5% since April 2019. There may be an exception to this rule if your employer chooses to pay more than its minimum requirement under the scheme.

In many cases, you may be able to contribute more than the minimum amount into your pension. In some cases, your employer will also contribute extra if you do this, so it’s worth checking.

How much does my employer need to pay into my workplace defined contribution pension scheme?

Under the auto-enrolment scheme, the total minimum contribution into your pension pot is 8% of your salary. Your employer must pay at least 3% of this. Some employers might voluntarily pay a higher amount into your pension. If so, you may be able to pay in less than 5%, as long as the total contribution is 8%.

If you voluntarily signed up to a pension outside of the auto-enrolment process, your employer’s contribution may be different.

What are the benefits of defined contribution pension schemes?

The main benefit of defined contribution pension schemes is that you get tax relief on the payments you make into the scheme. How the tax relief is applied depends on the scheme you’re a member of and how much tax you pay. For most schemes, the tax relief (or some of it, at least) is automatic.

• If you’re paying into a workplace scheme, your employer will usually take your pension contributions out of your pre-tax pay, so you’ll never pay tax on this money in the first place.
• If you’re paying into a personal pension, most schemes will apply something called “relief at source”. Under this system, every pension contribution you make will be topped up by your pension provider. It will claim enough from the government to account for the basic-rate (20%) tax most people will have paid on their income.

If you are a higher-rate taxpayer, you’ll need to claim the extra tax back from the government. This can be done either via a tax return or directly. This will also apply if your pension scheme doesn’t have automatic tax relief.

Where is the money in my defined contribution pension scheme held?

The money held in pensions is invested via a pension scheme provider. This is typically in a mixture of funds, stocks, shares and government bonds. Investing your pension pot allows it to grow much more substantially over time than if it was held in cash savings alone. As with all investments, performance can be volatile, and in the short term, the value can go down as well as up. Over the long period, you’re likely to be paying into a pension, however, the periods of growth should outweigh any temporary downturns.

Some schemes take a “de-risking” approach as you near retirement age. This is where your money is moved into increasingly lower-risk investments to avoid short-term volatility damaging the value of your pot just before you want to access it. Some of your pot may even be moved into cash savings.

Can I choose the investments in my defined contribution pension?

It depends on the type of pension you have. If you have a self-invested personal pension, you are responsible for managing your own investments. This includes choosing the investments in the first place. This means you can, for example, opt for higher-risk or more unusual investments than your money would usually be placed in. You also take on all of the risk of potential losses.

With other types of defined contribution pension (personal or workplace), you won’t typically have a say over which specific investments your money is held in. However, many schemes let you choose the broad plan, or strategy, for your investments. For example, depending on the scheme, you may be able to opt to invest mainly in lower-risk tracker funds or focus on ethical investments.

How much do defined contribution pensions cost?

You’ll pay for your defined contribution through a selection of charges that are usually taken directly from your pension pot.

At the very minimum, you’re likely to pay an annual management charge, or service charge, to cover the cost of administering your pension. This can be a percentage of your pot, a fixed fee or sometimes a combination. Charges for workplace pensions are typically lower than charges for personal pensions.

Other fees you might come across include transaction fees (when investments are bought or sold) and exit fees (sometimes payable when you transfer money out of one scheme into another).

Not every type of charge will apply to every scheme, and sometimes the same charge is called different things by different providers. But what is certain is that high charges can eat substantially into how much money you’ll be left with to fund your retirement. So, whenever you have a choice of scheme, it’s well worth comparing charges.

What happens to a workplace defined contribution pension if I change jobs?

If you change jobs but stay with the same employer, your pension scheme won’t be affected – though the amount you pay may change if your salary is different. If you move to a different employer, then the money paid into your pension by the time you leave (by you and your employer) is still yours.

You can choose to leave the money in the scheme where it is. Alternatively, you can consolidate it with another pension scheme. This can be an existing scheme or the scheme offered by your new employer. If you’re thinking of consolidating pensions, make sure you compare pension charges to make sure you’re not moving your money into a more expensive scheme. Check for any exit fees to leave a scheme too.

Make sure you keep hold of the details to log into your account and keep your details updated. In particular, let the provider know if you move house so that you carry on receiving your annual pension statements.

How much will my defined contribution pension pot be worth when I retire?

The value of your pot when you retire will be influenced by a number of factors, including the following:

• How much you and, if applicable, your employer pay in
• How well the investments perform
• How much any pension charges eat into your pot.

You can also choose to take a tax-free lump sum from your pension from age 55, even if you carry on working. Any money you take out before retirement will obviously affect how much is left when you retire.

When you receive annual statements from your provider, they should state how much you might have at retirement. This will be based on your scheme’s current value. MoneyHelper – the government-backed money-advice website – has a helpful pension calculator that can give you an estimate of how much you might get based on making certain contributions over your lifetime.

When can I access the money in a defined contribution pension?

The earliest you can typically take money out of your pension is age 55. You don’t have to have retired (or fully retired) from work to start taking your pension from this age. You can only access your pension pot before the age of 55 in exceptional circumstances, for example, if you need to retire early due to serious ill health.

How can I withdraw money from my defined contribution pension pot?

From the age of 55, you’re in control of what happens with the money in a defined contribution pension scheme. You have a few options. You can do just one of these or take a mix-and-match approach. And you don’t have to make a decision at age 55. If you want, you can just leave the whole lot invested until whatever age you need it.

The main thing to remember is that, for many people, your pension will be your main source of retirement income for the rest of your life. So you’ll need to bear this in mind when choosing when and how to access your money to avoid using it up too early.

• Withdraw 25% of your pension pot (excluding the state pension) as a tax-free cash lump sum.
• Leave your pot invested. If you have several pension pots, for example, you can leave some of them invested and access the money in others.
• Buy an annuity. This is where you use some or all of your pension pot to take out a form of insurance product that gives you a guaranteed income for the rest of your life (or for a fixed term, depending on the product). How much you’ll get varies between providers, so if you want an annuity, it’s worth shopping around.
• Leave most of the money invested and take a regular income, known as pension income drawdown. This has become one of, if not the, most popular pension withdrawal options. You can take out as much or as little income as you want. You pay income tax at the relevant rate, based on how much you withdraw over the year.
• Take the whole pot out and do with it as you wish. You should think carefully before doing this unless the pot is fairly small, however. Anything you take out above the 25% tax-free lump sum will be taxable. This could make for a higher tax bill than if you took out money more gradually.
• Withdraw lump sums as and when you need them, leaving the rest invested. If you choose this option, rather than being able to withdraw 25% as a single tax-free lump sum, the first 25% of each smaller lump sum you withdraw will be tax-free.

Do I pay tax on the money I take out of my pension?

In most cases, yes. You’ll pay income tax at the same rate as you would on employment income. The tax rate depends on how much total income you receive each year, from pensions and other sources.

Typically, the only exception to this rule is the 25% lump sum that you’re permitted to take out tax-free. This amount is based on the total value of all of your pension pots.

Pros and cons of defined contribution pensions

Bottom line

Defined contribution pension schemes may not offer the “gold-plated” guarantee of retirement income that defined benefit schemes do, but they’re still one of the best ways to save for later life. Not only do you get tax relief on contributions, but if you’re in a workplace scheme, your employer has to pay in too. This boosts your potential pension pot even further. With an average life expectancy in the UK of around 80, that’s a whole lot of life you’ll want to make sure you have the money to enjoy post-retirement.

Frequently asked questions

• Do I pay tax on my pension contributions?

  No. And, in fact, this is one of the major benefits of paying money into a pension. Pension tax relief applies to all types of pension, including both personal and workplace pensions. However, when you access your pension, most of the money you withdraw will be taxable.

• Is there a limit on how much I can pay into a defined contribution pension?

  Technically, there’s no limit on how much you can pay into a pension. But there is a limit on how much you can pay in and benefit from tax relief. Each year, you can contribute an amount equivalent to your annual earnings, up to a maximum of £60,000 for most people. Very high earners (we’re talking £240,000+ here) may have a lower annual allowance. You may also face a tax charge if, when you access your pension, the total value of your pension savings exceeds £1,073,100. This is known as the lifetime allowance.

• Can I have more than one defined contribution pension?

  Yes. You can hold and pay into multiple defined contribution pensions at the same time if you wish. For example, you may have both a workplace and a personal pension. Over time, as you change employers, you may find you end up with quite a few defined contribution pension pots.

• Can I merge multiple defined contribution pension pots into a single scheme?

  Yes. If you’ve changed jobs regularly and been enrolled into a new scheme with each provider, this could leave you with a fair bit of paperwork to stay on top of. If this is the case, it could be worth consolidating separate schemes into a single pot. This can be either with an existing scheme (as long as it accepts transfers in) or a brand new scheme. Make sure you compare the level of charges so you don’t end up moving money from a cheaper to a more expensive scheme.

• Is a defined contribution pension better than a defined benefit pension?

  The answer to this isn’t entirely black and white. It depends on the specific pension and your personal circumstances. There are pros and cons to both types of pension. For example, defined contribution pensions give you more control over what you do with the money in your pot when you retire. However, it’s generally agreed that defined benefit schemes are better for most people over their lifetime. They guarantee a (usually inflation-linked) income for life, and all the responsibility for funding that income lies with your employer. While you can buy an income (an annuity) with a defined contribution pension pot, the amount you’ll receive is likely to be much lower than the same contributions to a defined benefit scheme would get you.

• Can I take money from my defined contribution pension and carry on working?

  Yes. Provided you’ve reached the age of 55, you can usually access your money in any of the ways we’ve outlined in this article and carry on working. This can be either full or part time. You can even carry on contributing to your pension, even if you’ve taken out some benefits. One popular option is to take the 25% tax-free pension lump sum before stopping work, but leave the rest in place until officially choosing to retire. Bear in mind that you’ll pay tax on any withdrawals above that 25%. If you’re still working that means you’ll pay tax on your combined pension and employment income.

• Can I get advice on what to do with my defined contribution pension pot?

  Yes. For general guidance, you can contact the pension experts from the government’s MoneyHelper website. And when you approach retirement, you can book a free Pension Wise appointment with a specialist who will talk you through your options. If you want personalised, regulated advice based on your specific needs and circumstances, you can pay a financial adviser. You can find directories of qualified advisers on the MoneyHelper website, the Society of Later Life Advisers, The Personal Finance Society and Unbiased.
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Sources
1. MoneyHelper
2. The pensions regulator
3. ONS life expectancies
4. UK Government