What is a defined contribution pension?

Pension jargon can be confusing and may make you want to bury your head in the sand, but it’s vital to get to grips with which type of pension you have and how this will affect your income in retirement.

At the most basic level, there are two main types of pension: defined contribution pensions (also known as money purchase plans) and defined benefit pensions (or final salary schemes). They work in very different ways, so here, we walk you through what a defined contribution pension is, what your options are at retirement, and how to make sure your money is working as hard as it possibly can for you.

What is a defined contribution pension?

A defined contribution pension is a type of pension where the amount you receive when you retire depends on how much you have paid into it, how much your employer(s) has contributed (if it’s a workplace pension) and how the investments made on your behalf have fared.

Defined contribution pensions have become increasingly common in recent years as defined benefit pensions, which pay a guaranteed income in retirement, have become more expensive for employers to fund and therefore a less sustainable option. If you have been enrolled into a workplace pension scheme recently, or work for a private company or business, it’s likely that you will be in a defined contribution scheme. If you work in the public sector, you may have a defined benefit pension, but newer employees are starting to be enrolled in defined contribution pension plans, so you should always check with your employer if you’re not sure which type of pension you have.

How does a workplace defined contribution pension work?

If you have a workplace defined contribution pension, you will usually pay a set percentage of your wages into your pension over the course of your working life. The exact percentage you choose to pay is up to you, but if you have been auto-enrolled into your workplace pension scheme (see below for more on auto-enrolment), it is likely you are paying 5% of your salary into your pension each month, and your employer will contribute 3%, bringing total contributions to 8%. Your employer usually deducts your contributions from your salary before it is taxed.

You are usually able to pay in more than this if you want, and some companies will provide additional benefits to their employees through contribution matching, which means whatever you contribute they will match, or raise their contributions in line with it.

Many of us will be used to seeing our pension contributions coming out of our salary each month and not think too much of it, but regardless of whether you are 20 years from retirement or two, it’s worth considering if you should be paying more into your pension. Our article How much should I save for retirement? provides some suggestions to help you make the best decisions for you.

Will I always be auto-enrolled into a workplace defined contribution pension when I start a job?

Anyone who earns more than £10,000 a year will be automatically enrolled into their company’s workplace pension, and between their own and their employer’s contributions, at least 8% of their salary will go into their pension each month.

If you earn less than £10,000 a year you will not meet that auto-enrolment threshold, but this doesn’t mean you can’t join your company’s defined contribution pension. You can ask your employer to enroll you in your workplace pension scheme, and they can’t refuse. To read more about this, have a look at our article Can I join my workplace pension scheme if I’m on a low salary?

You are able to opt out of the scheme if you want to, but it’s worth noting that the aim of paying into your company scheme in the long term is to reduce your reliance on state pension, which alone is unlikely to provide you with a comfortable retirement.

Consumer group, Which? recently published some research which found that a comfortable retirement for a couple costs around £26,000 a year and £19,000 for a single person. This includes the maximum state pension which is currently £9,339 a year. Based on a retirement of around 20 years, to achieve this level of income you would need to build up a pot of anywhere between £154,700 and £305,710 (depending on how you choose to receive your retirement income). Read our article Can you afford to retire? to find out more.

How does a private defined contribution pension work?

If you don’t have access to a workplace pension, perhaps because you work for yourself, you might decide to pay into a private pension, which will usually be a defined contribution pension.

As with workplace defined contribution pensions, if you have a private defined contribution pension, you will build up your retirement savings by paying into your pension. The only real difference is that you won’t have the benefit of an employer’s contributions, but as with other kinds of pension, your returns will be protected from income tax, tax on dividends and capital gains tax, and you’ll also receive tax relief on your contributions.

Depending on which private or personal pension you choose, you may have access to a wide range of investments, which might appeal if you’re a more experienced investor and are comfortable managing your money on your own. For example, self-invested personal pensions (SIPPs), which are defined contribution pensions, allow you to invest in a wide range of investments from different providers, rather than only having access to the pension funds offered by just one provider. Find out more about SIPPs in our article Everything you need to know about SIPPs.

Where is my defined contribution pension invested?

Whether you have a workplace or a private defined contribution pension, your pension scheme provider will usually invest the money you place with them in a wide range of different assets, such as stocks and shares, bonds, property and cash.

While this may feel a little risky if you have never invested before, it is a standard practice for pension schemes and the aim is to grow your pension pot, making it more likely that when you retire you will have enough money for the retirement you want.

Most pension scheme providers will offer a range of different funds for you to choose from, but unless you request otherwise, your money will usually be invested into the scheme’s ‘default fund’. Default funds typically adapt the level of investment risk the closer you get to retirement. For example, when you are 40 your pension may be invested in higher risk investments, but the closer you come to retirement age, your savings may be moved into lower risk investments such as bonds and cash, to try to minimise the risk of any sudden stock market setbacks reducing the value of your pension pot just before you retire.

If you want to know more about how your pension scheme investments work, have a look at our article Where is my pension invested?

How much will my defined contribution pension provide me with when I retire?

In the broadest terms, the amount you’ll end up with at retirement from a defined contribution pension can be worked out like this:

The money you pay in (+ your employer’s contributions if applicable) x investment gains or losses

You should be sent an annual statement from your pension provider which tells you the current value of your pension. Once you have this, the Money Advice Service has a special pension calculator which can give you an estimate of the income you’ll get when you retire based on the current value of your retirement savings. The calculator factors in income from defined contribution and defined benefit scheme, plus the State Pension.

It’ll also show you whether you’re facing a shortfall and how much you need to save to make this up. If you’re planning to increase the amount you save, remember that there are limits on the amount you can pay into your pension and still benefit from tax relief. You can get tax relief on contributions up to an annual allowance of £40,000 or your annual earnings, whichever is lower. Read more about the different annual and lifetime pension allowances here.

When can I access and withdraw money from my defined contribution pension?

You can access your defined contribution pension from the age of 55. Once you reach this age, you can withdraw 25% of your pension without paying any tax and you can use this money however you want. However, there are downsides to consider if you’re planning to do this. You can find out more in our article Should I take a tax-free lump sum from my pension? You can use the remainder of your pension pot to provide you with an income. There are a number of ways to do this, such as through drawdown, or buying an annuity. We explain in more detail what your options in our article Your pension options at retirement.

What happens to my defined contribution pension when I die?

As defined contribution pensions are a scheme that you have actively paid into over your working life, if you die, you can usually pass your pension on to a named individual (or beneficiary). You usually nominate this person when you first sign up for your pension, but if you’re not sure whether you’ve already done this, check with your provider.

Depending on the age you are when you die, the person you are passing it on to may or may not have to pay tax on the amount they receive. For example, if you have a defined contribution pension and you die before you reach the age of 75, you can usually pass your pension tax-free to your nominated beneficiary. If you have not started taking money from your pension this can be taken as a lump sum payment.

However, if you die when you’re over the age of 75, your pension pot will still transfer tax-free, but your dependants will have to pay income tax at their marginal rate of income tax, on any income they receive from it, in the same way as you would have had to.You can read more about this in our article What happens to my pension when I die?

What are the advantages and disadvantages of a defined contribution pension?

One of the main benefits of a defined contribution pension is that as long as all the investments made on your behalf perform well, you have far more control over how and when you take an income from your retirement savings when you retire than you might have with a defined benefit pension.

That’s because in 2015 pension freedom rules were introduced which changed how people could access their defined contribution pensions and made it easier to take an income from your pension savings using drawdown. These rules only apply to defined contribution pensions and you can read more about it in our article Your options at retirement. You can learn more about drawdown in our article What is pension drawdown and how does it work?

These freedoms are not available for defined benefits or final salary pensions, which leaves a lot of people wondering whether they should transfer their final salary pension to a defined contribution one. It’s a complicated decision and involves giving up a valuable guaranteed income, so it’s essential to seek advice if you’re considering taking this route. Find out more in our article Should I transfer my final salary pension?

The main downside of a defined contribution pension is that it is possible that the investments made on your behalf through your pension scheme provider could make a loss, and you could lose a portion of your pension. Unlike a defined benefit pension where the majority of the risk for investment sits with your employer, who must provide scheme members with a guaranteed income at retirement, with a defined contribution pension there are no such guarantees and you must be comfortable accepting the risk that you could get back less than you put in.

Where can I find more information about my defined contribution pension?

If you’re 50 or over and have a defined contribution pension, you can get free guidance on the options available to you from the Government’s Pension Wise service.

If you want personal recommendations or advice about your specific circumstances, you’ll need to seek professional financial advice. You can find a local financial advisor on VouchedFor or Unbiased, or for more information, check out our guides on How to find the right financial advisor for you or How to get advice on your pension.

If you think you might be interested in speaking with a financial advisor, VouchedFor is currently offering Rest Less members a free pension check with a local well-rated financial advisor. There’s no obligation, but once you’ve had your check, the advisor will discuss the potential for an ongoing paid relationship if you think it might be useful to you.

Do you have a defined contribution pension, or are you already taking an income from your pension? We’d be interested to hear your views. You can join the money conversation on the Rest Less community or leave a comment below.

Links with an * by them are affiliate links which help Rest Less stay free to use as they can result in a payment or benefit to us. You can read more on how we make money here.

If you’re considering getting professional financial advice, VouchedFor is offering Rest Less members a free pension check with a local advisor. There’s no obligation but once you’ve had your review, the advisor will discuss the potential for an ongoing paid relationship if you think it might be useful to you.

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