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dc pension

A Guide to Defined Contribution Pension Schemes

What is a defined contribution pension?

A defined contribution pension is a type of pension that scheme that builds up a pot combing contributions from you and usually your employer. The scheme can be set up through your workplace or by you, independently. 

Your fund is then invested into stocks and shares and can grow depending on where its contributions are invested. 

If the scheme is set up by your employer, you will still have some say in where your contributions are invested.

If you set the scheme up yourself you can contribute whenever and whatever amount you choose, subject to some tax limits. If your scheme is organised through your workplace, your contributions are often deducted from your salary before they are subject to tax.

Defined contribution pensions are a type of private pension scheme. They are sometimes referred to as a DC pension or a ‘money purchase’ pension scheme. 

How does a defined contribution scheme differ from a defined benefit scheme?

The value of your pot:

  • With a defined benefit pension you are promised a specific income. 
  • However, with a defined contribution pension the amount you will accumulate can vary and there are no promises. 
  • It will depend on factors like the amount you pay in, the investment return, your charges and your retirement choices. 

Who funds the plan:

  • The main difference between the two rests on who funds the plan.
  •  A defined benefit scheme is usually funded by the employer. 
  • A defined contribution scheme, however, is based on contributions made by both employer and employee.
  • The employee defers a portion of their salary and the employer makes a contribution to match it up to the limit it sets. 
  • The contributions are then invested in the stock market

Flexibility:

  • Both schemes have the same end goal: giving you an income when you reach retirement.
  • However, defined contribution schemes are more flexible than defined benefit schemes 
  • There is also more variability in how much and when you choose to contribute. 
  • Although most DC schemes have a set contribution for the employee and employer, some will allow their members to choose the level of contribution.

defined contribution pension plan

How big will my pot be?

The size of your pot will depend on factors like:

  • The amount of time you save
  • The amount of money you pay in
  • Your life choices when you retire
  • How much you choose to withdraw as a lump sum
  • The amount your employer pays in (if applicable) 
  • Annuity rates (if you convert)
  • What charges your pension provider has withdrawn 

Tax relief on pension contributions 

Pensions are a tax-efficient form of saving because contributions are not subject to tax while invested in your pension pot. In a defined benefit contribution scheme, all contributions made by you or your employer are tax-deferred until withdrawals are being made. As you save, you get tax relief from the government. For example:

  • If you earn £30,000 a year, you contribute 3 percent of your salary (£900) and your employer matches your contribution also contributing 3 percent (£900), the government will give you tax relief at your tax rate (20 percent if you are a basic rate taxpayer)

With a DC pension, when you start withdrawing retirement benefits, you can take a quarter (25 percent) tax-free. Then you can use the rest of your pot for income subject to your standard income tax rates. 

Although there is no restriction on how much money you can withdraw in one go, there is a risk that if you withdraw a very large amount of your pot, you will be pushed into a higher tax bracket. 

However, no matter what amount of money you choose to withdraw, you will not be subject to any National Insurance charges. 

How much can I pay into a pension?

Most defined contribution schemes have a set contribution amount that depends on the employee’s salary:

  • For example, the employer and the employee contribute 5 percent of the employee’s salary accumulating 10 percent in total
  • However, some schemes will allow their members to choose the level of contribution.
  • It is worth remembering that rules about what constitutes your ‘earnings’ can vary from employer to employer.
  • These are called ‘pensionable earnings’ and equate to the amount used to calculate your pension contributions.
  • For example, some employers may not count overtime, bonuses, commission or any benefits that aren’t paid regularly to you. 

trust based defined contribution scheme

Defined contribution pension schemes are subject to the annual allowance:

  • This means there is a limit on the amount you can contribute annually
  • This is currently capped at £40,000, but a lower limit of £4000 can apply if you have already dipped into your pot. This is known as the money purchase allowance.
  • The annual allowance applies to all pension schemes you may be a part of and includes all contributions made into your pots – from you, your employer or anyone else that might pay into it. 
  • If you exceed the annual allowance you will not receive tax relief on any contributions you make and you could even receive a penalty charge.   

If you have a high income:

  • You might have a reduced, or ‘tapered’ annual allowance if your income is over £110,000; and  
  • Your adjusted income (all your income and your pension contributions) is above £150,000

What are the different types of defined contribution schemes?

There are a few ways to differentiate defined contribution schemes. In recent years, DC pensions have become more common following the closure of many defined benefit workplace pensions. 

The most popular types of DC pension schemes a UK employer offers are:

  • Group personal pensions (GPPs)
  • Group stakeholder pensions (GSHPs) 
  • Self-invested pension plans (SIPPs)
  • Group self-invested pension plans (GSIPPs)

Defined contribution schemes can also be differentiated by investment choice:

Trust-based schemes are pension schemes run by a board of trustees who oversee the management of your pension. They have a duty to you as a member of the scheme to get you the best deal. 

Master trusts

Schemes defined as a master trust:

  • Provide money purchase benefits 
  • Are used, or intended to be used by two or more employers
  • Are not used only by connected employers
  • Are not a public service pension scheme

In a master trust, although it is run by one trustee board, each employer has its own division within the ‘master arrangement.’ The board retains decision making independence for each division under a trust-wide governance structure.

The advantage of a master trust for the employer include:

  • Low operating costs
  • Greater simplicity than a single employer scheme

All trusts must be authorised by the Pensions Regulator

master trust

Group Personal Pension (GPP)

This means your employer has a pension provider, like an insurance company to run your scheme:

  • This type of defined contribution scheme is sometimes referred to as a ‘group personal pension.’
  • This type of defined benefit pension means that although your employer chose the provider, your pension is a separate contract between you and the pension provider.
  • The provider claims tax relief based on the value of your contributions and adds it to the fund 
  • A group personal pension will give you a lot greater choice in investment than a trust-based scheme. 
  • You can make additional voluntary contributions though an AVC facility either via your employer or directly with the provider

How are the funds invested?

  • Most money purchase schemes will offer you the choice of how you and your employer’s contributions are invested 
  • Your employer may pay for you to have some financial advice to help you decide where to invest.
  • Financial advice can be very useful for translating your attitude towards risk into your financial choices, so it is worth considering a financial advisor even if your employer does not offer you one.
  • You can decide to move your money between funds or redirect future contributions to a different fund.
  • Some employers decide to cover the cost of any changes to the pot so that it grows faster
  • You should be sent regular statements updating you on the value of your pot and you will be able to contact your scheme’s administrator to find out its value at any time.

When can I access my pension pot?

The pot can be accessed at any time from the age of 55. You have the choice to:

  • Withdraw your entire pot in one go. This would mean that 25 percent of your lump sum would be tax-free, but the rest would be subject to income tax
  • Withdraw lump sums when you need to, a quarter of each withdrawal will be tax-free (also known as UFPLS or Uncrystallised Funds Pension Lump Sum)
  • Withdraw a quarter of your pot tax-free, and then use the rest to provide a regular, taxable income
  • Withdraw a quarter of your pot tax-free, and then convert some (or all) the rest into an annuity (taxable retirement income)

You can learn more about your retirement options by watching this video:

What happens if my employer changes?

If you change jobs, you will stop paying into the pension set up by your employer. You might be able to leave it where it is, making it a deferred pension. However, if this is not possible you might want to transfer it to your new employer or transfer it into a personal pension scheme. 

With a group personal pension, when you change employment, it is normally automatically converted into a personal pension. This means you can carry on paying into it independently. However, you should check if your new employer offers a pension as it might be more financially beneficial, particularly if your new employer contributes. 

Things to think about

Whether to join the pension scheme:

  • Some employers will also contribute to the workplace pension they run, meaning you will lose out on these contributions if you opt-out, so unless you have very pressing financial concerns you should consider joining one of these schemes if it is offered.

Annuity:

  • Often, when you retire, your pension provider will offer you annuity dependent on your pot size. 
  • Annuities can provide you with a payable income for the rest of your life, or for a fixed number of years.
  • With a defined contribution pension you have a number of choices when you reach retirement, and one of these is to buy an annuity.
  • However, this is not necessarily the best choice for you or your own personal financial needs. If you are unsure you can seek advice from a regulated financial advisor. 
  • It is important to consider which type of annuity, if you purchase one at all, is the best for you. Once an annuity is purchased, it can be difficult or impossible to change it. 
  • Therefore, you must give it lots of thought as you could be making an irreversible decision.
  • They are offered by insurance companies  and there are a number of different types. You can read more about this here: https://www.pensionsadvisoryservice.org.uk/about-pensions/retirement-choices/buying-an-annuity-how-to-shop-around/types-of-annuity

Financial advice:

Retirement options and pension decisions can be confusing and overwhelming. So it is often a good idea to seek financial advice.

You can search for a regulated financial advisor using the Money Advice Service’s directory: https://directory.moneyadviceservice.org.uk/en?_ga=2.242517125.608356586.1582133105-1319735478.1574699549