Defined Contribution
WHAT IS A DEFINED CONTRIBUTION (DC) PENSION?
In the United Kingdom, Defined Contribution pensions, also known as Money Purchase schemes, have become the predominant type of pension plan. When you retire, the value of a Defined Contribution pension depends on the contributions made by you and/or your employer, the performance of your investment choices, and the amount of tax relief you receive.
Both you and your employer can contribute to your pension. Your pension provider will claim tax relief on your contributions and add it to your pension fund. Typically, the provider makes investment decisions on your behalf, allocating funds into various asset classes such as shares, property, bonds, and cash.
DEFINED CONTRIBUTION VS DEFINED BENEFIT PENSIONS
Defined Benefit schemes guarantee a certain income in retirement, which is a promise made by your employer. In contrast, Defined Contribution schemes do not offer a guaranteed income. The retirement income from a Defined Contribution scheme is based on the value of your pension pot at retirement. This pot will then be used to provide your income, with no assurance of how much it will be.
Defined Benefit schemes are managed collectively, whereas Defined Contribution schemes are individual accounts. In Defined Benefit schemes, the benefits are calculated using average member statistics, such as average life expectancy and salary increases. This collective model means some individuals may receive more benefits compared to others based on their longevity and dependent status.
INVESTING IN DEFINED CONTRIBUTION SCHEMES
One significant area of risk in Defined Contribution schemes is investment performance. Good investment returns can lead to a more comfortable retirement, while poor performance can negatively impact your pension pot. In Defined Benefit schemes, poor investment returns require the employer to cover any shortfall to meet the promised benefits.
Similarly, life expectancy affects these schemes differently. In Defined Contribution schemes, individuals need to ensure their savings last throughout their retirement, while in Defined Benefit schemes, the employer is responsible for covering the longer payment period if members live longer than expected.
There is no straightforward answer to whether a Defined Benefit or Defined Contribution scheme is better for an individual. The outcome depends on the quality of the scheme and the specific circumstances of the individual.
TRANSFERRING A DEFINED CONTRIBUTION PENSION
Transferring your Defined Contribution pension involves moving your pension funds from one provider to another. This can be as simple as switching funds within the same provider to achieve a better investment strategy or moving to a different provider for similar reasons.
CONSOLIDATING MULTIPLE PENSION SCHEMES
With the introduction of auto-enrolment in the UK, many individuals now have multiple pension pots. Consolidating these pensions can:
- Reduce Costs: Minimise the fees associated with multiple schemes
- Simplify Management: Make it easier to track your retirement investments and their performance
- Estimate Retirement Income: Provide a clearer picture of your projected retirement income and any shortfall
- Improve Visibility: Help you manage pension limits like the Lifetime Allowance
HOW TO TRANSFER YOUR PENSION
To transfer your Defined Contribution pensions, you (or your adviser) need to contact your current pension provider to check if a transfer is allowed and request an up-to-date valuation. Conducting an analysis to determine the suitability of the transfer based on your personal circumstances is crucial. Identifying an appropriate destination for the transfer ensures your retirement assets are managed effectively moving forward.
WITHDRAWING MONEY FROM YOUR DEFINED CONTRIBUTION PENSION
When you retire, you have several options for your defined contribution pension. If you’re at least 55, you can withdraw up to 25% as a tax-free lump sum (also known as ‘PCLS’ or ‘Payment Commencement Lump Sum’). The rest can remain invested, or you can use it to buy an annuity that guarantees an income for a specified period or for the rest of your life.
