In another recent blog post, we discussed defined benefit pensions and how they work. I promised that we would also cover Defined Contribution (DC) plans. These are more common and are more flexible than Defined Benefit (DB) Schemes but can also be seen as riskier as the risk of them sits with the employee, i.e. you.
It is maybe worth refreshing yourself on DB pensions before reading below, but both should help you understand your pension. It is important to say this blog is correct at the time of writing and based on the UK financial system, although there are many similarities internationally. So what do we need to know about DC schemes?
Defined contribution pensions are a type of retirement savings plan that employers and employees contribute to
A defined contribution pension is a retirement savings plan in which both employers and employees contribute money. The contributions are typically invested in stocks, bonds, or other assets, and the funds are used to provide retirees with income during their retirement years.
One advantage of defined contribution pensions is that they offer flexibility; employees can choose how much to contribute. Additionally, defined contribution plans often allow employees to keep their benefits if they leave their job before retirement. However, one downside of defined contribution pensions is that they may not provide enough income to cover all retirees' expenses. Additionally, the investment options available through defined contribution plans may not be ideal for all investors. As a result, it is important to carefully consider all factors before deciding whether a defined contribution pension is right for you.
The contributions are invested, and the employee can choose how the money is invested
A defined contribution plan is a type of retirement savings plan. The employee contributes a fixed sum of money to the plan, and the employer may or may not make additional contributions. The money in the plan is then invested, and the employee can choose how the money is invested. When the employee retires, they receive a retirement income based on the amount of money in the account. The defined contribution plan is different from a defined benefit plan, in which the employer promises to pay the employee a certain amount of money each month after retirement.
There is no guarantee of how much income the employee will receive with a defined contribution plan in retirement. However, defined contribution plans often offer employees more control over their retirement savings than defined benefit plans. Employees can choose how much to contribute to their defined contribution plans and decide how to invest the money in their accounts. Employees who are closer to retirement age may want to invest more conservatively, while younger employees may be able to afford more risk. As a result, employees who participate in defined contribution plans have greater certainty about their retirement income than those who participate in pension schemes.
When the employee retires, they receive a payout based on the contributions made and the investment returns
When an employee retires, they are typically eligible for a payout based on their contributions and the investment returns of their retirement plan. Employee contributions are typically made through payroll deductions, and investment decisions are made by the employee and their employer. The primary investments used in retirement plans are stocks, bonds, and mutual funds. While employee contributions are important, investment returns are the primary determinant of the size of the retirement payout. Therefore, employees must make wise investment decisions to maximise their retirement benefits.
A defined contribution pension is different from a defined benefit pension, which is a type of retirement plan where employers promise to pay retirees a certain amount of money each month
Pension plans are a vital part of many people's retirement planning. There are two main types of pension plans: defined benefit and defined contribution. A defined benefit pension plan is a type of pension where the employer promises to pay retirees a certain amount of money each month. The pension payment amount is based on the employee's salary and years of service. In contrast, a defined contribution pension plan is a pension in which the employee makes regular contributions to a pension pot.
The size of the pension pot will depend on the amount of money that is contributed and any investment returns that are earned. When the employee retires, they will receive a lump-sum payment from the pension pot. Again, the amount of money they receive will depend on the size of their pension pot and the performance of their investments. While both pension plans have advantages, defined contribution pension plans offer greater flexibility and control over retirement planning.
Defined contribution pensions are becoming more popular because they offer more flexibility than other types of retirement plans
The key advantage of a defined contribution pension is flexibility; workers can choose how much they want to contribute each month and access their pension pot. This flexibility makes defined contribution pensions ideal for self-employed people or who have irregular incomes. However, because the size of the pension pot depends on the markets, there is also a risk that it may not provide enough income in retirement. For this reason, many people choose to have both a defined benefit and a defined contribution pension.
Key benefits of defined contribution plans
Tax Benefits
One of the key benefits is the tax implication of putting money away in a pension for retirement. Because the government want us to save money for retirement, putting money into a defined contribution plan attracts an automatic 20% tax relief on saving in the pension.
If you are a basic rate taxpayer (i.e. 20%), this gives you back the money paid in tax through PAYE.
If you are a higher rate(40%) or additional (45%) rate taxpayer, you still get the 20% tax relief but can claim an additional 20/25% back in the following year's tax return.
This tax relief means you are paying into your pension from your gross (pre-tax) wage rather than your net (post-tax) wage. This makes investing in a pension one of the most tax-efficient ways of saving.
High savings amount
You can benefit from the above tax relief by putting in either £40k or 100% of your salary (whichever is less). This contribution level is a large amount that can be saved each year for retirement. It is important to remember that you will not be able to claim this before age 55 (currently), which will change shortly to 57.
Potential employer matching
Some employers operate a matching or a percentage matching scheme which can top up you. Again this can be an efficient way to build your pension pot. As employer's contributions paid are far less than administering a DB scheme, employers are keener to use this method to make workplace pension schemes more attractive.
Flexibility
With DB Schemes, the pension is administered by the employer, and if you leave an organisation, the pension is frozen until you retire, although you can have several DB schemes. With DC pension schemes, they can be moved either to a central scheme which you control or to your new employer, given much greater control of what happens to the fund as it builds.
Inheritance Tax Benefits
A lesser-known benefit of a DC pension scheme is its relation to inheritance tax. With a DB scheme, you receive your income until death then half of the income goes to your spouse. There is nothing left on a pension on their death, and it stops.
Key disadvantages of DC schemes
No guaranteed income
DC plans allow up to 25% of funds to be taken out in a tax-free lump sum at retirement up to the age of 75. The remainder can be drawn as needed but is subject to income tax. The fund can run out, meaning there is no indefinite income guarantee, especially if you live in ripe old age!
High fees
Financial service providers run DC schemes, and looking after your own DC scheme often requires the support of a financial adviser. The cost and fees associated with these services are highly variable, and care needs to be taken to ensure fees do not erode the
You can run out of money
Unlike a DB pension provider who will pay out indefinitely, A DC pension can run out of money depending on how investments perform, pension contributions and ultimately how long you live for.
Potential for the underperformance of fund/funds
As you are responsible (rather than the employer), the investments may perform in a way that you were not expecting. Often people feel their investments should perform between 5-7%, which may be an average. But if you retire just as the market crashes, you could be left with significantly less than you hoped for.
A way to mitigate against this is to reduce the level of risk in the investment approach to retirement.
Actionable Steps
1. Find out what pension you currently have. Is it a DC or DB plan?
2. If it is a DC Scheme - how much do you have in the pot? Is it enough? Do you need to save more? Can you save more regularly to take advantage of the tax benefits?
3. Is your investment risk - high, medium, or low? If you don't know, could you find out?
4. Figure out how much you will need in retirement? What would be a comfortable amount to pay the bills and live a comfortable lifestyle?
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Good luck on your journey!
Diarmaid
The information in his blog does not represent financial advice which is highly regulated but for educational purposes only. For proper financial advice, you should seek the advice of an FCA approved financial adviser
