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Defined contribution pensions

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A defined contribution pension scheme (sometimes called money purchase) is an occupational pension scheme. Your pension pot is built up from your contributions and your employer’s contributions (if applicable) plus investment returns and tax relief. The size of the pot will depend on how much has been paid in and how well it has done.

Once you retire the fund’s value is used to provide you with an income for life and can also be left for your dependents when you die. As with all types of pension, the amount you are permitted to contribute is limited to 100% of your relevant earnings, up to a maximum of £40,000 per year.

How Are My Contributions Invested?

The scheme provider invests the contributions on your behalf into a fund/s that give you access to a range of investments, typically in default multi-asset funds. Some providers allow you to choose how these investments are made up between different types of assets or different geographical areas.

This provides you with varying levels of risk and potential returns depending on how aggressive or conservative an approach you want to take. No tax is payable on income from investments or capital growth in the pension fund, provided they remain within the annual and lifetime allowances.

What happens if I die before my retirement?

Most schemes will pay out a lump sum that is typically two or four times your salary. In the event you die under age 75, the lump sum is tax-free. This type of pension usually also pays a taxable ‘survivor’s pension’ to your spouse, registered civil partner or dependent child.

If you die before your pension is due to start, the money that was paid in will go to whoever has been nominated as your beneficiary. They may either choose to use it for their own retirement or they can opt to receive the amount of any tax-free cash and then pass on whatever’s left of the fund, including any growth, as a death benefit to someone else who may also be able to treat it as part of their own pension fund.

Will my employer make contributions towards my pension?

If you work for an employer that operates a defined contribution scheme they will also have to contribute into your pension fund, although this is usually only if the contributions coming from yourself are at least equal to the minimum amount set by law. The scheme is made up of two parts – contributions from the employer or employee, and tax relief given by HM Revenue & Customs (HMRC), which comes out of taxpayers’ money.

Employers contribute alongside staff, but the government gives extra money through tax relief on top of the money the employer and employee contribute.

Tax relief on an employer’s contribution is given at the current basic rate of 20%, meaning that for every £1 an employee contributes, their employer must also make a contribution of £1. HMRC then reduces their liability by giving tax relief equal to 20% of this employee contribution. That means it costs the company 80p and the government only pays out 20p for every £1 they contribute.

So if your employer saves £100 into your pension fund, the cost to them is actually only £80 because they receive tax relief, and, because you pay tax on your income, some or all of that tax relief will be refunded through your PAYE code.

Tax relief on a contribution from an employed person is given at the same rate as their income tax, which means basic rate tax relief of 20%. So if you contribute £100 to your pension, HMRC reduces your liability by giving you tax relief equal to 20% of this amount. That means it costs you £80 and the government gives out only £20 for every £1 contributed.

Who runs my defined contribution pension scheme?

If you are a member of an occupational pension scheme it is not your employer who is responsible for your pension but an insurance company or financial institution. Employers only contribute on behalf of their staff usually via an arrangement with an insurance company or investment firm called a master trust. It is the master trust that appoints the money manager of the scheme, the person who decides where to invest your savings. This could be one individual person working in-house for the master trust provider or alternatively there may be several managers working at different organisations making up what is known as a multi-manager arrangement.

What are my options to take my pension pot at retirement?

Once you reach age 55, you have access to your defined contribution schemes pension pot. You could take some or all of it, to use as you need, or leave it so that it has the potential to continue to grow. Its up to you how you take the benefits from your pension pot. You can take your benefits in a number of different ways but it will also depend on the rules of your defined contribution scheme.

You can choose to buy a guaranteed income for life called an annuity. You can take some, or all, of your pension pot as a cash lump sum, or you can leave it invested via flexi-access drawdown, or a combination of each. However you decide to take your benefits, you will normally be able to take up to 25% of your pension pot tax-free. The rest will be subject to income tax at your highest rate of tax.

Its good to have choices when it comes to pensions and your retirement, but it is also important to understand all your options and any impact your decision may have on your future financial security. How long your pension pot lasts will ultimately depend on the choices you make. You can read more about the various methods of withdrawing from your pension in our Pension Withdrawal knowledge article.

The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future. You should seek professional financial advice to ensure you fully understand your options at retirement.

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