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.
If you need help with deciding how to invest your contributions, follow the link below:
Stage 2 – When you retire
You can access and use your pension pot in any way you wish from age 55.
- 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 for the year.
- 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 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 annuity).
The size of your pension pot and amount of income you get when you retire will depend on:
- How long you save for
- How much you pay into your pot
- The choices you make when you retire
- How much you take as a cash lump sum
- How well your investments have performed
- How much your employer pays in (if a workplace pension
- Annuity rates at the time you retire – if you choose the annuity route
- What charges have been taken out of your pot by your pension provider
When you retire, your pension provider will usually offer you a retirement income (an annuity) based on your pot size, but you don’t have to take this and it isn’t your only option.
If you’re unsure about your options and how they work, you can get free and impartial guidance from Pension Wise, a government-backed service run by The Pensions Advisory Service and Citizens Advice.
But the Pension Wise service can’t tell you which option is best for you.
If you’re at all uncertain about what to do, get advice from a regulated financial adviser.
You can find details of regulated financial advisers in our Retirement adviser directory.
Find out more about your pension pot options with our Retirement income options tool.
If after getting advice you think an annuity is right for you, always shop around for a better rate.
What you need to think about
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 might increase as you get older.
For example your employer might be prepared to match your contribution on a like-for-like basis up to a certain level, but could be more generous.
What happens if you change jobs?
If you change jobs, you stop paying into the pension and might be able to leave it where it is. This is called a preserved or deferred pension.
If you are not able – or do not want – to remain in the pension, you might want to transfer it to your new employer, or to a stakeholder or personal pension, but there are risks and costs associated with this.
Did you find this guide helpful?
Thank you for your feedback