These are usually either personal or stakeholder pensions. They’re sometimes called ‘money purchase’ pension schemes. They can be either a workplace pension arranged by your employer or private pension arranged by you.
Money paid in by you or your employer is put into investments (eg shares) by the pension provider. The value of your pension pot can go up or down depending on how the investments perform.
With a defined contribution pension you build up a pot of money that you can then use to provide an income in retirement. Unlike defined benefit schemes, which promise a specific income, the income you might get from a defined contribution scheme depends on factors including the amount you pay in, the fund’s investment performance and the choices you make at retirement.
What is a defined contribution pension?
Defined contribution pensions build up a pension pot using your contributions and your employer’s contributions (if applicable) plus investment returns and tax relief.
If you’re a member of the scheme through your workplace, then your employer usually deducts your contributions from your salary before it is taxed. If you’ve set the scheme up for yourself, you arrange the contributions yourself.
It helps to think of defined contribution pensions as having two stages.
Stage 1 – While you are working
The fund is usually invested in stocks and shares, along with other investments, with the aim of growing it over the years before you retire. You can usually choose from a range of funds to invest in. Remember though that the value of investments can go up or down.
Stage 2 – When you retire
You can access and use your pension pot in any way you wish from age 55. You can:
Take your whole pension pot as a lump sum in one go. A quarter (25%) will be tax free and the rest will be subject to Income Tax and taxed in the usual way. Bear in mind that a large lump sum could tip you into a higher tax bracket.
Take lump sums as and when you need them. A quarter of each lump sum will be tax free and the rest will be subject to Income Tax and taxed in the usual way. Bear in mind that a large lump sum could tip you into a higher tax bracket for the year.
Take a quarter of your pension pot (or of the amount you allocate for income drawdown as a tax-free lump sum, then use the rest to provide a regular taxable income.
Take a quarter of your pot as a tax-free lump sum and then convert some or all of the rest into a taxable retirement income (known as an pension annuity).
The size of your pension pot and amount of income you get when you retire will depend on:
how much you pay into your pot
how long you save for
how much your employer pays in
how well your investments have performed
what charges have been taken out
the choices you make when you retire
Things to consider
If your work gives you access to a pension that your employer will pay into, staying out is like turning down the offer of a pay rise. Unless you really can’t afford to contribute or your priority is dealing with unmanageable debt, it makes sense to join.
The amount your employer puts in can depend on how much you’re willing to save, and may increase as you get older. For example your employer may be prepared to match your contribution on a like-for-like basis up to a certain level, but could be more generous.