What to know about defined contribution pension schemes before you retire
A defined contribution pension can be a private pension or a workplace pension and is a way to save for retirement that can combine your contributions, employer contributions, investment returns and tax relief. Once you retire, you can turn that lump sum into an income.
A defined contribution pension is the most common way to save for retirement in the UK. As the name suggests you build a pension through your own contributions as well as payments from the taxman and, if it is a workplace scheme, your employer.
Read on to find out more.
What is a defined contribution pension?
A defined contribution pension is a retirement savings vehicle where you pay into it yourself and enjoy tax relief on those payments. You may also receive contributions from your employer too if it is a workplace pension.
Unlike defined benefit or final salary pensions, your eventual pot is not guaranteed and depends on how much you manage to save as well as how your investments perform.
How does a defined contribution plan work?
The idea of a defined contribution pension plan is that, during your working lifetime you make regular payments – contributions – in order to slowly build up a fund that is big enough to provide you with an income in retirement.
For most people this means that part of your monthly salary is paid into your pension while you are working. This monthly contribution is boosted by the government who refund the income tax you’ve paid on it. Known as tax relief this boosts basic rate taxpayers’ contributions by 20% while higher rate taxpayers get 40% pension tax relief.
Your employer may also make a monthly contribution to your pension. Find out more with our guide to pension contributions.
The money you pay into your pension is then invested in a range of investments.
When you retire you need to decide how to use the money you have amassed in your defined contribution pension to give you a retirement income. This could be to take it as a lump sum, draw a regular income from it, buy an annuity or a combination of all three. Find out more with our guide to accessing your pension.
» MORE: How to plan your pension
How big will my defined contribution pension be?
The size of your defined contribution pension when you retire depends on a number of factors including:
- How long you have been making contributions
- How much you have paid in
- How much your employer has contributed
- The performance of your investments
- What pension charges you have paid
There are a number of ways you can boost your pension. Read our guide to pension planning to find out more.
Taking a tax-free lump sum
Once you are 55 (57 from 2028) you are able to take up to 25% of your defined contribution pension as a tax-free lump sum. But just because you can doesn’t mean you should. For some people accessing that cash will mean clearing the last of their mortgage or other debts so that they can live more comfortably in retirement. However, you should think carefully before you take it. If you don’t plan to retire for another 10-15 years, then taking that money may have a significant impact on your eventual retirement income. Leave it invested and it could help your pension grow further.
» MORE: Pension tax relief explained
Turning a defined contribution pension into a retirement income
If all has gone well when it is time to retire, your defined contribution pension could contain a sizeable amount of money (the lifetime allowance for pensions - the maximum it can grow to before additional tax charges are applied - is currently £1,073,100).
Once you retire you need to turn that lump sum into an income that will last you throughout your retirement. Your pension is likely to be the largest amount of money you ever have, and it is vital that it lasts as long as you need it to. So, what you do with it is a big decision.
You have a number of options:
- Annuity – You could use your pension to buy an annuity that will give you a guaranteed income for life.
- Income drawdown – You could keep your pension invested but take a regular income or lump sums as and when you need them.
- Cash withdrawal – You could take all of your pension as a lump sum in one go to live off, although only 25% will be tax-free, the remainder will be taxed.
- Mix it up – You could do a combination of these different options.
While you received tax relief when you were paying money into your defined contribution pension when you start taking money out most of it is liable for income tax. So, you need to factor tax into your decision on how to access your cash.
You can get advice on how to turn your pension into an income. Everyone aged over 55 is entitled to a free pension guidance appointment with the government’s PensionWise service. If you want specific advice tailored to your situation you can consult an independent financial adviser, although you would need to pay a fee.
» MORE: Pension rates
WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you may get back less than originally paid in.
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Ruth is a freelance journalist with 15 years of experience writing for national newspapers, magazines and websites. Specialising in savings, investments, pensions and property. Read more