What is a defined contribution pension plan?

What is a defined contribution pension plan?

A defined contribution, or money purchase, pension scheme is the most common type of workplace pension these days. It is built up through your own contributions, those of your employer and tax relief from the government.

Defined contribution schemes give you an accumulated sum when you come to retire that you can use to secure a pension income through buying a product called an annuity, or opt for income drawdown. You can also take the lot as a lump sum - but may face a hefty tax bill. 

Most company pension schemes are now defined contribution.

This guide explains how they work and what you need to do to get the highest possible income in retirement.

Defined contribution pensions - how they work

Until 2012, you would have been asked by your employer if you want to join the company scheme. However, from 2012 onwards, automatic enrolment was introduced, requiring all UK workplaces to enrol their staff in pensions.

Go further: Pension auto-enrolment: how it works - read our expert guide to the new pension rules.

Your employer will deduct your contributions from your salary before its taxed. They will also usually contribute a percentage to your pension. You'll also get tax relief from the government, too, which can boost the amount you're saving. It works like this.

• You earn £30,000 a year.
• You contribute 3% to your pension (£900).
• Your employer contributes 3% (£900).
• The government gives you tax relief on your contributions at your tax rate (20%).
• This is equivalent to £225 a year.
• Your total annual saving into your pension is £2,025.

If you're a higher or additional-rate taxpayer, you'll need to claim the additional rebate through your tax return.

Go further: Pension tax relief - learn more about how your pension interacts with tax

Defined contribution pensions - what happens to my savings?

The contributions from you and your employer will be invested in the stock market, with the aim of growing it over the years before you retire.

Unlike those who belong to a defined benefit pension scheme, members of defined contribution schemes have a degree of choice as to where their pension contributions are invested. Many opt to put their money in the scheme's 'default fund' - a fund that has a mix of different assets.

You could choose more risky investments to maximise your growth, as you'll be saving for a long time until you retire.

Go further: Different types of investment - find out more about the different types of investment products

Defined contribution pensions - who manages my money?

There are two main types of defined contribution pension scheme:

Trust-based schemes

These types of pension schemes are run by a board of trustees that oversees the management and investments in your pension. The trustees choose the professionals who look after your money and have a duty to you as the member of the scheme to get the best deal on your behalf.

Contract-based schemes

If you're in a contracted-based pension, it means that your employer has appointed a pension provider, such as an insurance company, to run your pension scheme. These are sometimes called 'group personal pensions.'

The contract is not between you and your employer, but between you and the pension provider. These types of schemes often offer you a much greater choice in investments for your pension savings than a trust-based scheme.

Defined contribution pensions - how much will you get?

The amount of retirement income you'll end up with depends on:

• how much you contribute each month - you can usually choose to increase this
• how much your employer contributes
• how long you contribute for
• how well the investments perform
• how much any charges eat into your pot
• how much you take as a cash lump sum

Defined contribution pensions - how do you get a decent income in retirement?

How much retirement income should you aim for?

It can be tricky to know how much you'll need to survive on in your retirement. You might have paid off your mortgage and will no longer have to meet the travel cost of the daily commute. However, how much will need to pay for the day-to-day essentials?

For the past five years, the Pensions and Lifetime Savings Association (PLSA), a pensions industry body, has developed its retirement living standards to help people with this question. The standards set out three levels of expenditure – minimum, moderate and comfortable – designed to guide savers trying to figure out the amount of money required to deliver the lifestyle they want in retirement. Each standard is based on the actual cost of a basket of goods and services.

The PLSA has set the level of annual income required by a couple at £22,400 (for the minimum standard), £43,100 (moderate) and £59,000 (comfortable) in 2024. The surge in inflation and more money put aside to help out family members have pushed up these totals significantly compared with 2023.

For a single person, the minimum, moderate and comfortable retirement living standards this year are £14,400, £31,300 and £43,100. While the targets for single retirees might seem high compared with those for couples, this reflects the fact that many costs – such as energy bills, broadband and home insurance – remain virtually the same whether you live alone or not. 

For more: How much will you need to retire?

How to gauge if you're on track for a comfortable retirement

These annual income figures can seem like pretty challenging targets when you're trying to cope with all your other expenditure while in employment.

Starting to contribute to a pension as early as possible is a good idea - that's why you shouldn't opt out of an auto-enrolled work pension.

The Which? pension calculator will show you how much your pension might grow by, based on how much you (and your employer) contribute until you reach retirement age.

Pension calculator - how much will I have?

We've made some assumptions on how much your pension will grow by each year, as well as the amount you lose to pension charges.

We have assumed your funds grow by 6% per year, and you pay annual charges of 0.75%. We've also factored in inflation, at 2% a year.

Using your pot to get income in retirement

When you reach your retirement date, you'll need to use your pension pot - all of your savings over the years and all the growth they've gained through investment on the stock market - to buy an income.

At this point, you can buy an annuity, which is a product designed to give you a guaranteed income for the rest of your life, or enter into income drawdown. This sees you leaving your money invested in the stock market and drawing an income from it. You can also take the pot in one go (subject to taxation) or in chunks.

How much income you get will depend on how much you have in your pension pot. Since April 2015, you've been able to withdraw as much of the money as you want when you reach 55, although it is taxed as income.

Your full pension options are outlined in our guide to turning your defined contribution pot into a retirement income.

Taking a tax-free lump sum

When you retire, you can take up to 25% of your pension savings as a tax-free lump sum. This reduces your pension income, but may be worthwhile if you need the money - to pay off outstanding debts, for example. The earliest you can draw a pension or take a lump sum is age 55.

Go further: Should I take a lump sum from my pension? - weigh up your options at retirement.

Why should you join your workplace pension?

Joining a company pension scheme is a must. Not only are you putting something aside to have a comfortable life in the future, but you're also getting free money from the government and your employer for doing so.

Under the government's auto-enrolment rules, total contributions must now be at least 8% of an employee's earnings- of which the employer's contribution must be at least 3%.

Contributions will also benefit from pension tax relief. This means that they're taken from your salary before any tax has been deducted.

The effect of tax relief is that a contribution of £100 that would have been taxed at 20%, and therefore worth £80 net, is paid into your pension fund without any deduction - so it's worth the full £100.

For 40% taxpayers, the impact is even greater. If you're in a DC pension scheme, this is particularly significant, as it boosts the size of the contribution going into your pension. This means you will have a bigger pot when you retire.

What happens to my pension when I change jobs?

If you have left a job, you can transfer your pot to the scheme at your new workplace. However, this can be complicated. If you are transferring out of a defined benefit scheme into a defined contribution scheme, for example, you should consider the fact that you are giving up a promised payment at retirement.

Transferring defined contribution schemes is much easier - you can just take the funds with you. However, it's worth watching out for any exit fees imposed and the annual management charges on the new scheme, which could decrease your pot.