Defined contribution pensions
Nowadays, the most common type of pension is a defined contribution pension, which is also known as a money purchase pension.
The chances are that most people have one of these pensions, whether they opened the plan personally or through their employer’s sponsored pension scheme.
Defined contribution pensions allow you to build up a fund for retirement through the payment of regular contributions which are typically invested in the stock market.
What is a defined contribution pension?
A defined contribution pension is a pot of money intended for retirement. The amount you have on reaching retirement with which to provide an income depends on how much you pay into the plan and the investment return you achieve.
The pension can either be a workplace scheme arranged by your employer or a personal plan arranged yourself.
The money paid into the plan, by you or your employer, can be invested or remain in cash, depending on your preference and appetite for investment risk.
You can often choose which funds to invest in however your employer may provide a default investment fund. Some defined contribution pensions allow you to invest in individual stocks or commercial property. It’s important to remember when considering investing that your money can go down as well as up and it is therefore best to speak to a financial adviser if you are unsure.
At present, individuals can access their defined contribution pension plans from age 55, however, the minimum pension age will be rising to age 57 from 2028.
Advantages of having a defined contribution plan
Defined contribution pensions have many benefits, but they are particularly known for being incredibly tax efficient and flexible with respect to how you can take your benefits and how you can pass them to your loved ones on death.
Pension contributions are an incredibly tax efficient way to build savings for your retirement. When paying into your pension, you automatically receive basic rate tax relief on top of your contribution.
So, for example, every £80 you put into your pension, this will be grossed up to £100. 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 and receive tax relief, which is capped at £60,000 per annum. If you don’t have any earnings, you are still able to contribute £3,600 gross per annum.
Some workplace schemes have additional benefits, such as your employer matching contributions and salary sacrifice. Matching contributions is where an employer increases their overall contributions if you also agree to pay more in, to 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.
All investment growth within pensions is exempt from capital gains tax and income tax. This means that assets within pension funds have the opportunity to make faster, bigger gains over time.
Additionally, your pension funds can remain invested up until and into retirement, even after you begin to withdraw your funds, again allowing for greater potential gains. This point is key as you may still have many years of retirement to provide for once you begin taking a retirement income.
When the time does come to withdraw money from your pension, defined contribution pensions allow you a vast array of flexibility. Prior to 2015, one option was to purchase an annuity with your pension funds which would simply provide you with a guaranteed income for life. When the new pension freedoms rules were introduced in 2015, the way in which funds could be taken from pensions completely changed. Under the new regime, it is now possible to access your pension funds using what is known as flexi-access drawdown.
This new regime allows you to take up to 25% of your pension pot completely tax free - subject to an overall limit of £268,275 for most individuals - with the remainder taken as income 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. On top of this, you still have the option to use all, or part, of your fund to purchase an annuity at any time.
Another advantage of defined contribution pensions is how the pensions are treated on death. Most pensions are deemed to sit outside of your estate and therefore you are able to pass defined contribution pensions onto your nominated beneficiaries free of inheritance tax.
There is a quirk in the rules, that if you die before age 75 any income your beneficiaries take from the plan will be free of income tax. Should you die after age 75, your beneficiaries can take an income from the pension pot at their marginal rate of income tax.
What are the best defined contribution pension plans?
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 stakeholder pensions, personal pensions and self-invested personal pensions.
Group personal pensions are plans that employers set up for their employees as part of their workplace pension obligations. Stakeholder pensions are designed to be universally accessible and they are characterised by their lower minimum contribution amounts and lower costs. Self-invested personal pensions, or SIPPs, are similar to other defined contribution plans, the main difference being that they offer a much wider range of investments to choose from.
Group personal pensions
In this pension, the employer chooses the provider that runs the scheme and sometimes narrows down the funds that staff can invest in, often choosing a default fund for everyone. These plans typically invest in lifestyle funds which automatically de-risk your pension investments as you approach your designated retirement age to protect your funds from market risk. These plans are simple, and your employer gives you a helping hand but it’s important to remember that the default fund may not be in line with your personal views and attitude to investment risk. Some older plans may also not have adopted the pension freedom rules in retirement and on death and therefore it is best to check the details of each of these plans.
These often have default investment strategies which is great if you want something simpler with not too much choice. However, if you want a wider range of investment options, these plans may not be suitable for you. Sometimes these plans are used by employers but they can also be set up individually. The main drawback of stakeholder pensions is they typically do not facilitate flexi-access drawdown so unless you want to purchase an annuity, these plans may not fit your needs.
Self-invested personal pensions
SIPPs allow you to invest in commercial property and as you would expect, these pensions offer flexi-access drawdown at retirement. SIPPs typically have higher costs compared to other defined contribution pensions due to the additional functionality they offer.
Defined benefit pension plan vs defined contribution pension plan
Defined benefit pensions, also known as final salary or career average pensions, are quite different to defined contribution plans.
These plans will pay out a fixed guaranteed income for life when you retire. This is very different to defined contribution plans where the income is not guaranteed, and instead is based on the value of your pension pot when you retire.
The level of pension income you receive is based on your salary, the scheme accrual rate and how long you have worked for your employer. This type of pension scheme is less common now and many employers have closed their schemes to new members.
They are incredibly advantageous if you have one as they give you a guaranteed income for life.
Can I transfer my defined contribution pension?
Not all plans will be suited to your individual needs, whether it be the underlying investment choice or the option to use flexi-access drawdown. The good news is that you have the option to transfer your defined contribution pension into a new plan that suits your needs.
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.
There are many points to consider before transferring a pension and it is therefore important to seek advice if you are unsure what is best for your personal needs.
It is also possible to transfer a defined benefit pension into a defined contribution pension; this is an extremely complex area of advice and it is necessary to speak to a professional if you are considering doing so.
How we can help
Pensions are complex and there is plenty to think about 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. Alternatively, you can also get in touch with one of our advisers and arrange a free initial consultation.
Please note: A pension is a long-term investment not normally accessible until age 55 (57 from April 2028 unless the plan has a protected pension age). The value of your investments (and any income from them) can down as well as up which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change. You should seek advice to understand your options at retirement. The Financial Conduct Authority do not regulate tax planning.