What is a defined contribution pension?

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

This kind of pension involves saving up a pot of money over many years, to be held in investments until you reach your chosen retirement age (55 or over).

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

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.

The only exceptions are the defined benefit pensions frequently offered in public sector jobs, and (increasingly rarely) by a few private sector firms.

Traditionally defined contribution pensions have been seen as inferior to defined benefit ones – but they do hold certain advantages over them too.

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, then 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 pension for yourself, you arrange how much you contribute.

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

The choice of investments is designed to deliver growth over the very long term – i.e. several decades.

Your pension provider will also claim tax relief on your employee pension contributions, and add this amount to your pension pot.

Tax relief is a hugely important benefit of pensions, as it effectively adds 25% to every contribution you make. 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 via the other two methods.

What are the advantages of a defined contribution pension?

The advantage of a defined contribution pension (as oppose to no pension at all) is simply that it allows you to build up substantial investments 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 that it’s more flexible (even if it may not be as generous or dependable).

You can access the money in a number of different ways, varying your income and choosing how much (if any) to guarantee, which can make this kind of pension more suitable 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 defined contribution pension, however, is that it’s inheritable.

Any unspent pension pot can be passed on to your beneficiaries after your death, completely tax free.

This can make your pension an extremely good vehicle for reducing or eliminating an inheritance tax bill – for instance, you could aim to spend other (taxable) assets first, and leave your pension till last. This way, there can be more for your family to inherit.

Defined benefit pensions have no such advantage – once you die, they can’t be passed on (though they may continue to cover your spouse at a reduced rate).

Defined contribution pensions are also not dependent on your employer’s solvency.

With defined benefit pensions there is a small but not zero risk that if the employer becomes insolvent, the pension scheme might collapse and be unable to pay out the full amount.

With a defined contribution pension there is no such risk, as the fund is independent of the employer.

What are the disadvantages of a defined contribution pension?

The main disadvantage of a defined contribution pension is that 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 that 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 is that 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 bear in mind is that 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 the money in that is not taxable at all.

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 will be paid off and you won’t need to fund a daily commute, you’ll need less money each month.

However, there are still day-to-day essentials to pay for and, hopefully, a few luxuries.

According to a survey conducted by consumer watchdog Which?, their members revealed that the average retired household spends just under £2,250 a month, which is around £27,000 a year.

This covers all the basic areas of expenditure (an average combined cost of £18,000 a year) and some luxuries, such as European holidays, hobbies and eating out.

However, if you include luxuries such as long-haul trips and a new car every five years, you’ll need closer to £42,000 a year.

So, what is a good pension amount? Some advisers recommend that 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 in the normal way 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 remain ten years below State Pension age

There are also some circumstances when you may be able to 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 the scheme. 

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 defined contribution 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?

Technically you can withdraw your pot in one go, or in chunks.

You can take 25% tax free and the rest will be taxed at the normal rate of income tax.

This means taking pension pots as a lump sum is highly inadvisable unless the pot is very small.

What happens to my defined contribution pension when I die?

If you die before age 75, any unspent pension pot will pass tax-free to your beneficiaries, provided the money is paid within two years of the provider becoming aware of your death.

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

If you die before the age of 75, what they receive will be taxed as income (but they have the same choices as to how they receive it).

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.

However, these can sometimes be paid to a dependent child, usually until that child is aged around 23, depending on the rules of the annuity provider.

Talk to a financial adviser about the best ways to access your defined contribution pension.