How do defined contribution pensions work?
Our comparison of Defined Benefit vs Defined Contribution Pensions offers some initial insight into how defined contributions pensions work. But now let’s take a deeper dive into DC pensions so you’re fully informed about your options.
What is a defined contribution pension?
With a defined contribution pension, the clue is in the name. The ‘contributions’ you make towards your pension are ‘defined’, and these contributions will in turn play the largest role in defining the final pension you receive.
Other things that will influence the final pension you receive, and the payments you drawdown over the course of your retirement, include:
Your contributions: How much money you pay into your pension
Employer contributions: How much money your employer pays into your pension
Tax relief: How much tax relief you get on your contributions based on your tax bracket
Investment returns: How the investments made with your pension fund perform
Fees and charges: The costs for the management of the scheme you are part of
How different types of defined contribution pensions work
There are several others, but the main two types of DC pension scheme are:
A workplace pension: In this setup the pension is controlled by your employer. Both you and your employer make contributions to your pension throughout your time working for them. After you stop working for them. With some exceptions for high tax bracket earners, your contributions will automatically have tax relief applied via the PAYE system. Almost all employers should have these schemes now following the introduction of ‘auto-enrolment’ workplace pensions in the UK.
A personal pension: A pension you set up yourself. This can be a separate pension to your employer managed pension, or if you are self-employed it may be your main pension. Either way, you will be the only one making contributions. You will still get tax relief from the government, but as contributions are not made via PAYE, tax relief will automatically be applied for by whoever is managing your scheme. Again, with some exceptions for high earners.
How are defined contribution pensions managed?
Workplace DC Pensions: Most people who are part of a workplace pension scheme will be invested in something known as the ‘default scheme’. This is an expertly designed and managed scheme with the goal to maximise returns while balancing risk based on how close you are to retirement. In some cases, employer schemes also give you the choice between a range of different funds as alternatives to the default.
Personal DC Pensions: If you have a personal pension, to various extents you can choose your own investments. However, many private pension providers also offer ‘retirement defaults’ where you just pay in your contributions and let the investment experts do the rest. This is much like the default option of a workplace pension, but without your employer making contributions or paying the management fees to the provider.
There are also many online pension platforms nowadays, offering you a quiz to assess how much risk you can take and determine which investments you’d prefer to hold. However, we would strongly advise seeking more detailed advice from expert financial advisors to secure your future.
Lastly, if you have a Self-Invested Pension Plan (SIPP), you will be responsible for your investment decisions and managing the pot yourself. This can be incredibly risky without doing a lot of research, and that itself is enormously time consuming.
If you’re thinking of managing your own investments you should seek advice from expert retirement planning advisors like Lomond Wealth before starting, and at regular points during your career and retirement.
What if the pension scheme doesn’t grow fast enough?
Unlike a DB pension, the benefits of a DC pension are not defined or fixed. This means that the performance of your investments will have a direct impact on the pension you receive. If the investments perform poorly, you may have less than expected when you retire or choose to retire a little later. If they perform better than expected, you may end up with a larger pot when you retire or choose to retire sooner.
Investment performance may continue to impact your income levels after you retire. In some cases, poor performance could mean there is a time you have less to live on than expected, while strong returns could let you treat yourself to an extra holiday or new set of golf clubs. However, this will depend on how you have chosen to withdraw your DC pension, as there are various options.
Withdrawing money from a DC pension
In the UK, the current age for accessing your DC pension, regardless or type or where it is managed, is 55. However, this will rise to 57 from 2028.
Once you reach retirement age, you have a range of choices in how you want to receive your pension. You can even opt for a mix and match approach between the different options. However, not all schemes offer every alternative. You may need to transfer your pension to another provider to get what you want.
What ways can I withdraw my DC pension?
Annuity: An annuity is a guaranteed income for life. Almost like a DB pension. It takes the uncertainty of investment performance out of play. You can also choose from different benefits, such as linking your income to inflation so you don’t fall behind the cost of living, or making sure for your spouse will still receive money when you pass away. You can also take 25% of your pension up front as a lump sum, tax-free. Your annuity payments will be taxed at your marginal rate
Drawdown: With the drawdown option, you take out a tax-free 25% lump sum from your pension and leave the rest of the money invested. You can then ‘drawdown’ your income a regular payments or by taking out money as and when you need it. It is worth noting that different providers have different rules about how you can access the cash.
Lump sums (UFPLUS): Your pension stays invested and you take lump sums when you need them. Instead of taking the 25% tax-free up front, a quarter of every sum is tax free whenever you draw it.
By leaving money invested with a drawdown or UFPLUS option, your pot has the chance to earn returns, but investments can always still go down as well as up. It is important to seek expert advice when deciding on the best path for your retirement.
Will my DC pension keep up with inflation?
If you choose an annuity and opt for a benefit that links to inflation, then yes. If you choose to take your pension via a drawdown or UFPLUS option, then your investments may outperform or underperform against inflation based on the market. There are benefits and risks to all options that should be considered.
How is my DC pension taxed?
During your career, the government gives you tax relief on DC pension contributions you make to your pot. This is capped at £60,000 of contributions per year, or whatever your taxable earnings were that year – whichever is less. For example, if you earn £45,000 from your job, you can only receive tax relief on contributions up to £45,000 that year. We can advise you on how to maximise this, or even to invest more than your annual allowance in certain scenarios, just ask us how.
During retirement, you will receive 25% of your pension tax-free. Exactly how this 25% comes to you will depend on the way you choose to withdraw your pension. All other payments you receive from your pension will be taxed at your nominal income tax rate.
Learn more about paying tax in retirement – How will my pension be taxed?
What happens to my DC pension when I die?
As things stand, some defined contribution pensions can be passed to a spouse or loved one tax-free. However, from April 2027, money left in your pension, as well as death benefits, will be deemed part of your estate and subject to Inheritance Tax.
How your beneficiaries choose to take the money and how much tax they will ultimately pay on it depends on a number of factors.
If you have not started to withdraw from the pension yet, your beneficiaries can:
- withdraw all the money as a lump sum.
- set up a guaranteed income (an annuity) with the proceeds.
- set up a flexible retirement income, called ‘pension drawdown’.
If you have already started to withdraw from the pension before you die, your beneficiaries can:
- take the remaining money left as a lump sum.
- set up a guaranteed income (an annuity) with the proceeds.
- Potentially continue the flexible retirement income of the ‘pension drawdown’.
In the case that you already used the pension to set up an annuity before you die, the amount your beneficiaries receive will depend on the options or benefits linked to the annuity you selected.
It could also be the case that, if you die after the age of 75 your beneficiaries pay no tax on the remaining pension you leave behind.
In short, there are many scenarios and ripples that make passing on a pension complex. Seeking expert advice early on will make sure your loved ones are looked after when the time comes.
Can I transfer my defined benefit pension?
Yes. One of the main reasons people transfer DC pensions is to merge pots from different employers. We can even help you uncover any lost pots you might have forgotten about.
Another reason is that some schemes have benefits that others do not. You might want to transfer to a scheme that offers benefits that better suit your desires for retirement. This can also impact how your remaining pension pot can be passed on to loved ones when you die.
Can Lomond Wealth advise me about my DC pension?
Of course. It’s always a good idea to seek advice when choosing a pension plan or considering a pension transfer. This will help you find the right balance of benefits, or even just the best pension for you in terms of risk and investment style.
If you have any questions regarding your DC pension and retirement plan, please get in touch.
Lomond Wealth is ranked in the Financial Times’ Top 100 UK Advisors and is proud to provide straightforward advice you can trust.
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