What is a defined contribution pension scheme?

A defined contribution (DC) pension is the most common type available and is used in both workplace pension schemes and personal pensions.

This kind of pension involves saving up a pot of money over many years to be held in investments until you access it at age 55 (57 from 2028) when you can start taking money out of your DC pension. 

This kind of pension gives you lots of control over your retirement income but carries a certain amount of risk and can be challenging to manage.

Here are the main things you need to know about defined contribution schemes.

What is a defined contribution pension?

Defined contribution pensions, also known as ‘money purchase’ pensions, can either be a personal pension arranged by you directly with a pension provider, or a workplace pension arranged by your employer.

Defined contribution pensions include:

• Executive pension plans
• Group personal pensions
• Master trust pension (e.g. NEST, NOW pension, the People’s Pension)
• SIPP (Self Invested Personal Pensions)
• SSAS (Small Self-Administered Schemes)
• Stakeholder pensions

In short, the vast majority of pension are defined contribution.

If you work in the public sector, you will likely have a defined benefit pension. This type of scheme is increasingly rare in the private sector, although many still have existing pensions built up with previous employers.

Although defined contribution pensions are less generous than defined benefit schemes, they do have some limited advantages over them.

How does a defined contribution pension plan work?

Defined contribution pensions build up a pension pot using your contributions and your employer’s contributions (if applicable).

If you have a workplace pension, your employer usually deducts your contributions from your salary before it’s taxed and adds their own (at least 3% of your salary, perhaps more).

If you’ve set up a personal pension, separate from your employer scheme, you arrange how much you contribute.

All your contributions will be invested in the stock market (in various assets) inside a protective tax wrapper that will mean the growth is tax-free.

The choice of investments is designed to deliver growth over many decades.

Your pension provider will also claim tax relief on your employee pension contributions and add this to your pension pot. In Scotland, the rates of tax relief may differ slightly due to variations in income tax bands.

Tax relief is a hugely important benefit of pensions, as it effectively adds 20% to every contribution you make if you’re a basic-rate taxpayer. Higher and additional rate taxpayers can claim further relief via their self-assessment tax returns. Find out more about how tax relief works.

From the age of 55 (this is set to rise to 57 from 2028), you can then start to access your pension.

There are a range of ways you can do this, including drawing a flexible income (drawdown) and/or purchasing a guaranteed income (an annuity).

You can also take 25% of your pot as a tax-free lump sum. Any larger amount will be subject to income tax at the normal rate, as will any income you take after your tax-free lump sum.

What are the advantages of a defined contribution pension?

The advantage of a DC pension (as opposed to no pension at all) is simply it allows you to build up a substantial pot for retirement, with major tax advantages that you can’t get any other way.

This makes pensions the best accessible form of investment for retirement when looking at the balance of risk, reward, and liquidity (i.e., how easy it is to access your money).

The advantage of a defined contribution pension versus a defined benefit pension is it’s more flexible (even if it may not be as generous or dependable).

You can access the money in many ways, varying your income and choosing how much (if any) to guarantee. This flexibility is great if you want to phase your retirement or continue earning occasionally after you retire.

You can even continue saving into your pension and receive tax relief up to the age of 75.

Perhaps the single biggest advantage of a DC pension, however, is it’s inheritable. Any unspent pension pot can be passed on to your beneficiaries after death, allowing you to provide for your loved ones.

In contrast, defined benefit pensions are designed to pay you an income while you’re alive. There is no pension pot to pass on to loved ones. 

Instead, once you die, your scheme may pay a reduced income to a dependent such as a husband, wife, civil partner or child under 23.

What are the disadvantages of a defined contribution pension?

The main disadvantage of a defined contribution pension is it’s a finite pot of money that can run out (unless you use it to buy an annuity).

Your investments are also subject to stock market performance, meaning a significant market crash can reduce your retirement savings.

That said, this is true of any investment involving the stock market. Pension funds are generally well-managed and designed to protect you from last-minute slumps before retirement.

Another perceived disadvantage, compared to an individual savings account (ISA) or other investments, is you can’t access the money till you’re 55 or over. But this is only sensible, as you want it to last for the rest of your life.

One last thing to remember is the money you take out of a pension is taxable because it counts as income (except for the first 25%).

This is where a lifetime ISA holds some advantages over a pension, as withdrawals after the age of 60 are tax-free, though the contribution limits are much lower compared to a pension.

What is the difference between a defined benefit and a defined contribution pension plan?

Defined benefit pensions are always workplace pensions.

They pay you a guaranteed annual income from a set date, known as your ordinary retirement date (usually 65 or 60, depending on the employer).

They are also known as ‘final salary’ or ‘average salary’ pensions.

How much you get will depend on your salary, how long you’ve worked for your employer and a calculation made under the rules of your pension scheme.

Your employer is responsible for ensuring there’s enough money at the time you retire to pay your pension income.

By contrast, with a defined contribution pension, the amount you’ll get when you retire won’t be specified in advance.

The amount you’ll end up with in retirement will depend on:

• How much you contribute each month
• How much your employer contributes each month
• How well the investments perform
• How much any pension plan arrangement charges will cost
• The method(s) you choose to access your pension pot

You can explore more on the topic of defined benefit vs defined contribution here.

How much should I be contributing to my defined contribution pension?

It’s not easy to know exactly how much you’ll need to live on in your retirement.

If your mortgage is paid off and you won’t need to fund a commute, you’ll need less money each month. However, there are still day-to-day essentials to pay for and, hopefully, a few luxuries.

To achieve a comfortable standard of living in retirement, you'll need approximately £43,100 a year after tax for a single-person household or £59,000 for a two-person household, according to the Pension and Lifetime Savings Association (PLSA) retirement living standards.

This amount would cover all essential expenses and allow for some luxuries, such as long-haul trips and a new car every five years. 

If you prefer a more moderate lifestyle, you’d need about £31,300 after tax annually for a single person or £43,100 for a couple. This includes some luxuries but at a lower level of expenditure. 

So, what is a good pension amount? Some advisers recommend you save up to 10 times your average working-life salary by the time you retire.

So, if your average salary is £30,000, you should aim for a pension pot of around £300,000.

To find out how much income you’ll have from your private pensions and how much you’ll need, use the Unbiased Pension Calculator.

When can I access my defined contribution pension?

Legally you can start to access your pension from the age of 55 – well before you can receive your state pension.

However, the government has confirmed plans to increase the minimum pension age from 55 to 57 from 2028, alongside planned increases in the state pension age to 67.

From then on, the minimum pension age will be 10 years below the state pension age.

There are also some circumstances when you can access your pension earlier than 55, such as if you’re in poor health or in a profession where your normal retirement age is earlier than normal, for example, if you’re a professional athlete.

You may also have a protected pension age lower than 55 under the rules of certain pension schemes. 

If you’re a member of a workplace pension scheme, you generally require the consent of the employer or ex-employer to take benefits early. In some instances, you may also need the consent of the pension scheme trustees.

If you have a private DC pension, you don’t need the consent of an employer or the pension provider to take benefits early if the terms and conditions of your contract allow you to do this.

Generally, it’s best to wait as long as possible before accessing your pension, as it has to last you for the rest of your life. You may also want your family to inherit some of it.

Can I cash in my defined contribution pension?

You can withdraw your pot in one go, or in a series of lump sums.

You can take 25% of your pension pot tax-free, and the remaining 75% will be taxed as income at your marginal rate. This means taking pension pots as a lump sum is generally inadvisable.

All your income will fall in one tax year, potentially landing you with a big tax bill.

For most people, it makes sense to withdraw smaller amounts over time, particularly if you are trying to avoid paying more tax.

What happens to my defined contribution pension when I die?

If you die before age 75, any unspent pension pot will pass to the beneficiaries named in your expression of wishes form. 

They can take it as a lump sum, drawdown, or an annuity.

If you’ve chosen to buy a joint annuity when you retire, this will typically be paid to your spouse or civil partner for the rest of their life.

What are the tax rules on inherited pensions?

The tax rules on inherited pensions are complicated, and it’s important to get advice.

Although inherited pensions are currently free from inheritance tax (IHT), there may be tax to pay from April 2027 because the tax rules are changing.

Your beneficiaries could be charged up to 40% IHT on pension wealth they inherit, depending on your other assets and available allowances.

Your beneficiaries may also need to pay income tax on an inherited pension, depending on your age when you die.

If you die after 75, the remaining pension will be taxed at the beneficiary’s marginal income tax rate. However, if you die before 75, then there will be no income tax to pay. Tax-free withdrawals are restricted by the lump sum and death benefit allowance (LDSBA) rules. 

Get expert financial advice

A defined contribution pension offers a flexible and tax-efficient way to save for retirement, allowing you to build a substantial pot over time through regular contributions and investment growth.

While it provides significant control over how you access and use your funds, it also comes with risks. Market fluctuations can impact the value of your pension, and there’s no guaranteed income. 

By understanding these factors and planning accordingly, you can make informed decisions to help ensure your retirement is comfortable and financially secure.

Let Unbiased match you with a financial adviser for expert financial advice and tailored guidance on managing your DC pension and maximising its benefits for your retirement planning.