Defined contribution pensions
Nowadays, the most common type of pension is a defined contribution pension, which is also known as a money purchase pension.
If you have set up a pension, either personally or through your employer, the chances are one of these.
A defined contribution pension enables you to save money tax-efficiently for your retirement through regular contributions. The contribution is defined but the amount of money you will receive from your pension pot when you retire is not. It will depend on the performance of the investments that your money is held in, which is why it is very important to understand how your defined contribution pension scheme works.
What is a defined contribution pension?
A defined contribution pension is a scheme that enables you to invest money for your retirement. The value of your pension pot and the income you will be able to derive from it when you reach retirement will depend on how much you invest and the return your investment achieves.
A defined contribution pension can be arranged as a workplace scheme, or you can set one up yourself. Often employers will agree to make contributions to a scheme that you set up personally if you request them to do so.
The money contributed to your pension, whether by you or your employer, is usually invested in to underlying assets, such as funds, shares, etc. The choice of these assets is dependent on the type of pension scheme you have, your circumstances, your attitude to risk, and the time until your retirement.
Your employer may provide a default investment selection, But you can often choose which funds to invest in. Some defined contribution pensions give you the flexibility to invest into all sorts of different assets, from individual stocks and bonds to commercial property and commodities. Because the value of these types of investments can go down as well as up, it's important to speak to a financial advisor to make sure you are fully aware of the risks.
At the moment, you can access your defined contribution pension from age 55, however, the minimum pension age will rise to age 57 from 2028.
What are the benefits of DC pensions?
Defined contribution pensions have many benefits, especially when it comes to tax efficiency and flexibility over how you can take your pension benefits and how you can pass them to your loved ones on death.
Tax benefits of defined contribution pensions
Because the government wants to incentivise retirement saving, your contributions to a defined contribution pension automatically receive basic rate tax relief. This effectively tops up your contribution. This means that for every 80p you put into your pension, the government will automatically top it up to £1.
If you are a higher or additional rate taxpayer, you can claim any additional tax due back via self-assessment.
You can contribute up to 100% of your earnings (capped at £40,000 (2021-2022) and receive tax relief. If you are not working or have no income, you are still allowed to contribute £3,600 per year.
Pensions are exempt from capital gains tax and income tax so all investment growth within your pension plan will grow gross. Because your investments are growing gross, they have the opportunity to make faster, bigger gains over time, than the same assets would if you held them outside of a pension plan.
Occupational pension scheme benefits
Many occupational pension schemes offer additional benefits, such as your employer matching contributions and salary sacrifice. Matching contributions is where your employer increases their overall contributions if you also agree to pay more, into a matched pre-agreed percentage.
Salary sacrifice is where an employer offers you the option of giving up part of your salary in exchange for a higher pension contribution, therefore saving on income tax and National Insurance Contributions. Your employer may also top up your pension contribution with the National Insurance they save as an additional bonus.
Pension drawdown
When you reach your retirement age you will want to start drawing an income from your pension. Defined contribution pensions give you a great deal of flexibility over how you do this.
Before the Pensions Freedoms legislation was introduced in 2015, it was mandatory to use the proceeds of your pension pot to buy an annuity. After the rules were introduced, the way in which you can take money from your pension has changed, enabling you to access your pension pot using what is known as flexible drawdown.
Under the new rules, you can take up to 25% of your pension pot completely tax-free - this is called your Pension-Commencement Lump Sum (PCLS). The remaining must be taken as income and is taxed at your marginal rate of income tax. The increased flexibility means you can withdraw your entire pot as a lump sum, take ad hoc lump sums, take a regular income, or a combination of these to suit your needs. Of course, you can still opt to buy an annuity if this fits better with your requirements.
Defined benefit pensions on death
Another major benefit of a defined contribution pension is the way they are treated on death. Pensions are deemed to sit outside of your estate for inheritance tax. If you die before the age of 75, you can leave your pensions to your nominated beneficiaries free of inheritance tax.
If you die after age 75, you can leave your pension pot to your beneficiaries and they can take an income from and pay tax at their marginal rate of income tax.
What types of DC schemes are available?
There are several different types of defined contribution pensions, so it is important to understand the differences in order to choose one that is right for your needs. The most common types are group personal pensions, stakeholder pensions and self-invested personal pensions.
Group personal pensions
With this type of pension, your employer selects the pension plan provider and sometimes narrows down the choice of investment funds that you can select. Often your employer will select a default fund for everyone. Group personal pensions normally invest in lifestyle funds - these are funds that automatically change the investment allocations from growth to cautious as you approach your retirement age.
While these sorts of plans are low-maintenance, it’s important to remember that the default fund selection may not be in line with your personal views and attitude to investment risk. Also, due to the limited choice of funds available, it is rare for the selected funds to ever consistently outperform other funds in their category or the market. By limiting your options, you may also be limiting your growth potential.
Some older group schemes do not adopt the pension freedom rules in retirement and on death and therefore it is best to check the details of each of these plans to see if you are restricting your options, especially if you have left your employer and are no longer contributing to your group scheme.
Stakeholder pensions
Stakeholder pensions are great if you want something simpler with not too much choice, and are usually cheaper than other types of pension, but if you want a wider range of investment options, these plans may not be suitable for you.
Stakeholder pensions are often used by smaller employers because they offer a low-cost solution with a default investment strategy. They also used to be a popular choice for people wishing to set up a personal pension and especially for the self-employed. With the advent of SIPPs and the introduction of the Pensions Freedoms legislation, Stakeholder schemes have lost their popularity are now considered by many to be obsolete.
The main drawback of stakeholder pensions is they typically do not facilitate flexible drawdown so unless you want to purchase an annuity, these plans may not fit your needs.
Self-invested personal pensions (SIPPs)
A SIPP enables you to invest in all sorts of assets. Everything from commercial property to gold bullion. You can even invest in your own business. SIPPs also offer flexible drawdown at retirement. They are as close as you can get to the ultimate flexible retirement account and offer a huge number of benefits to investors. However, because a SIPP may require additional administration, especially when certain types of assets are held, they can be more costly.
There are a number of low-cost SIPPs available today that operate in very much the same way as an online trading account, only because they are classified as a pension by HMRC, they offer huge tax benefits.
Small Self-Administered Schemes (SSAS)
Small self-administered pension schemes (SSAS) are small occupational pensions that are normally utilized by directors or senior employees in a business. The maximum number of members permitted in a SSAS is limited to twelve. SSASs are often also open to family members of employees, even if they do not work for the employer.
It is possible to set up a SSAS as a defined benefit pension scheme, however, this is rarely done. Usually, a company will help its employees set up a SSAS as a defined contribution pension, so the value of your SSAS is dependent on the amount you or your employer contributes and the performance of the investments in your pension plan.
Your scheme trustees, who typically are scheme members, hold the assets on a collective basis. Each member is then entitled to a proportion of the assets based on the value of contributions made on their behalf and the growth on the overall value of the assets in the SSAS.
The major benefit of setting up a SSAS for the company is that it is possible to own the company's premises and lease them back to the firm. Companies can also lend themselves money from the SSAS, or purchase company shares, which helps the company managed its financing activities.
Qualified Recognised Overseas Pension Schemes (QROPS)
Most QROPS offer a similar choice of investments as SIPPs, however, they are overseas schemes and may provide specific benefits for certain individuals, especially if they are living outside of the UK.
The tax benefits described above may not apply to QROPS. You should consult an appropriately qualified Independent Financial Advisor for information and advice on QROPS.
Is a DC pension better than a DB pension?
A Defined benefit pension (often referred to as a final salary pension), is very different from a defined contribution pension. With a defined benefit plan, when you retire your employer guarantees to pay you a fixed percentage of your salary for life. This means your employer takes complete responsibility for ensuring your retirement income is paid.
With a defined contribution pension, your income is not guaranteed and is dependent on the value of your pension pot when you retire. If you do not make enough contributions or your investments perform poorly, your retirement income could be impaired.
Because a defined benefit pension guarantees your income for life, it is usually preferred over a defined contribution scheme. However, because of the huge burden defined benefit schemes put on employer's finances, defined benefit pensions are far less common now and many employers have closed their schemes to new members altogether.
Can you transfer your DC pension?
Your circumstances may change and you will likely change jobs many times during your lifetime and contribute to many pension schemes. This means that you may end up with pensions that no longer meet your needs or are suitable for you.
There are numerous reasons why you may wish to transfer your pensions, it may be that you have lots of previous employer pensions that you would like to consolidate into one easily accessible place. Perhaps the investment choice of your current pension doesn’t offer the funds you would like to invest in, or you want the freedom to choose individual stocks. Many older schemes have not adopted the pension freedom rules on retirement or death and it may be necessary to move to a ‘new world’ pension.
Defined contribution schemes allow you to transfer your pension pot. Whether this means moving your pot over to a new employer's group pension scheme, or consolidating old pensions in a SIPP, the ability to transfer your pension, helps you ensure that your new plan better suits your needs and lets you keep in control of your money.
What is the next step?
Pensions are complex and you need to ensure that you are armed with the correct information, based on your personal circumstances and objectives, in order to make an informed choice when choosing, or transferring, any pension plan. It is recommended that you take professional financial advice to ensure that you have the correct plan to meet your needs and that you are on track to meet your retirement goals.
Connect with an expert through our network of UK-qualified Independent Financial Advisors. Through our introduction, you will be entitled to a free, no-obligation pension review.