A guide to defined contribution pension schemes

Written by Retirement Line

Last Updated: 18th July 2024

How do defined contribution pensions work?

As you approach retirement it is important to understand the various pension schemes that hold your money. Defined contribution (DC) pensions, sometimes called ‘money purchase’, are the most common form of retirement savings scheme.

If you have one of these schemes, understanding how they work and the options you will have is crucial for making informed decisions about your financial future.

We have put the following information together to help get you started. For further information specific to your pension schemes, you might wish to speak to a financial adviser.

• What is a defined contribution pension scheme?

• What is auto enrolment for defined contribution workplace pensions?

• Tax relief on DC pension schemes

• Types of DC scheme

• What are collective defined contribution (CDC) schemes?

• When and how can I take my defined contribution pension money?

• Do I pay tax on defined contribution pensions?

• Can I consolidate my defined contribution schemes?

• Purchasing an annuity from a defined contribution fund

What is a defined contribution pension scheme?

Unlike traditional defined benefit (DB) pensions, where the employer guarantees a specific retirement income based on factors like salary and years of service, defined contribution (DC) pensions operate differently. 

With a DC pension, you make contributions to your pension pot, which is then invested to grow over time:

• If you have a private DC pension scheme, you will make contributions to it regularly or as and when you wish. 

• If you are a member of a workplace DC pension scheme, you and your employer will typically make regular contributions to it, usually based on a percentage of your salary.

Whether you have a private or workplace pension in the UK, you can get tax relief on your contributions to boost your fund further. (We explain more on this below.)

Your pension pot builds over time. The eventual size of your pot at retirement depends on both the size of the contributions made and the investment performance of your pension scheme. The scheme will typically invest in a range of assets such as stocks and bonds.

You would likely hope that your pot builds to a level so that it can provide a sufficient income for your retirement, usually on top of your State Pension income.

As a defined contribution scheme member, you are typically able to your investments to ensure they align with your retirement goals and how much investment risk you wish to take. When you approach retirement age, some schemes may automatically move your pension savings into lower-risk investments (called ‘lifestyling’). If they do not offer this, you could ask your pension provider if you can do this yourself.

What is auto enrolment for defined contribution workplace pensions?

Paying into a workplace pension used to be optional for most workers. However, since automatic enrolment was introduced in 2012, all employers must now enrol their eligible employees into a workplace pension scheme.

Eligible workers are those who are at least 22 years old but below the State Pension age, earn more than a certain amount (£10,000 per year in the 2022/23 tax year) and work in the UK.

Once enrolled, employees contribute a percentage of their qualifying earnings into the pension scheme. This contribution is deducted from their salary before tax is applied – known as ‘salary sacrifice’ – making it a tax-efficient way to save for retirement.

There is normally a minimum contribution that you and your employer must make each month. Typically this is 5% from you (including tax relief) and 3% from your employer.

If you do not wish to make contributions to your workplace pension fund, then you can opt out of the scheme after you’ve been enrolled. But if you do this, your employer’s contributions will also stop, and you will lose out on the government’s contribution to your fund in the form of tax relief.

Tax relief on DC pension schemes

Defined contribution pension holders benefit from tax relief when saving your money. Your employer will usually deduct your pension contributions from your salary before tax is applied. This can help minimise the amount of tax you pay, whilst giving your pension fund a boost.

For each contribution made, your pension provider will also claim tax relief from the government at the basic rate of 20%. They then add this to your pension fund, which adds up to a significant benefit for pension savers.

Types of DC scheme

There are several types of defined contribution pension schemes including:

Workplace schemes

One form of a workplace scheme is where your employer sets up its own unique scheme with a provider. All of the members of the scheme will be employees of the same firm. 

Another type is a group personal pension (GPP). This is where you join a scheme chosen by your employer, but employees of other companies will also be members of the same scheme.

Similar to a GPP, a master trust pension (also known as a ‘multi-employer pension scheme’) is a workplace scheme that multiple unrelated employers can use. Trustees look after pension savings on behalf of all the employees who are members. Examples include NEST, The People’s Pension and Now Pension.

A Small Self-Administered Scheme (SSAS) is a pension scheme normally set up by a small limited company. An employer can self-manage the scheme and members can have a say in investments and even use their SSAS pension to invest in the company.

Note that ‘workplace pension’ can also refer to a defined benefit scheme, which operates differently to a defined contribution scheme. 

Individual pension schemes

There are a number of different types of non-workplace scheme, with two of the main types being these:

• Self Invested Personal Pensions (SIPP). Many people ask “Is a SIPP a defined contribution pension scheme?” and the answer is yes. A SIPP is a personal pension scheme that typically gives you more control of your retirement savings than other DC schemes. In particular, you have more flexibility over the way your pension pot is invested.
  

• Stakeholder pensions. This is a type of individual pension scheme provided by a bank, building society, insurance company or trade union. A stakeholder pension typically invests in a small range of funds, which are chosen on your behalf by the provider, though you may be given some choice.

What are collective defined contribution (CDC) schemes? 

Collective defined contribution (CDC) refers to a specific type of hybrid pension scheme designed to provide a middle ground between the two traditional types of pension models.

Whilst the specific features and regulations surrounding CDC pension schemes can vary, the base format tends to remain the same. Typically, a collective defined contribution pension collects your contributions each month like a standard DC scheme does. However, employee funds are pooled together and invested collectively to deliver a retirement income for life.

These schemes aim to provide more predictable retirement benefits than traditional defined contribution schemes, while also maintaining some level of flexibility and risk-sharing. You should also consider that the income can fluctuate with performance, and is not guaranteed.

When and how can I take my defined contribution pension money?

The normal minimum pension age (NMPA) – the age that you can typically access your pension savings – is currently 55, though this is increasing to 57 from 2028. 

This means that from 55+ you can choose how you access your defined contribution scheme. How you do this depends on your future wants and needs for retirement. You have several key options:

Purchase an annuity. You can use your pension savings to buy a pension annuity for guaranteed regular income for life or a fixed term. Your guaranteed income is dependent on factors such as your age, health and annuity rates at the time of purchase. You can typically take up to 25% of your pot tax free and use the rest to buy the annuity, with the income taxable.

Pension drawdown. With pension drawdown, you can keep your pension fund invested and withdraw money as and when you need it. As with annuities, you can usually take up to 25% of your pension pot tax-free, and the remaining funds can be drawn gradually, subject to income tax.

Mix of drawdown and annuity. You can choose a combination of pension drawdown and an annuity. This blended approach enables you to keep some of your funds invested, whilst having the reassurance of a guaranteed annuity income from some of your savings.

Take cash lump sums. You can leave your money in your existing pension scheme and take money as and when you wish. The first 25% of each withdrawal will be tax-free, and the rest taxable. 

Leave the money invested. If you don't need income from your pension savings now, you can leave your pension fund in your current pension scheme. This option allows your savings to potentially continue growing, although it could also lose value if investment performance is poor.

Do I pay tax on defined contribution pensions?

From age 55 you can currently access your defined contribution fund however you wish, though the tax implications of your options may sway how you choose to proceed.

In terms of your tax-free entitlement, it is usually just the first 25% that you can access tax-free. The rest is taxable at your marginal rate of income tax. So if you take a lump sum or income which pushes you into a higher tax bracket, the tax rate you pay will increase.

The table below explains how tax will apply depending on how you access your fund from the age of 55:

From tax year 2024/25 the maximum amount a scheme member can take as a tax-free lump sum will be frozen at £268,275. This is known as the ‘lump sum allowance.’ If you have lifetime allowance protection, then this amount may be different for you.

Can I consolidate my defined contribution schemes?

Yes, if you have several defined contribution schemes then you may choose to consolidate them into one single fund. You might wish to do this if you have built up a number of smaller pension pots over your career with different employers.

Consolidating your pension schemes can simplify your retirement planning by creating one manageable fund to make decisions about. Consolidating may also reduce your future costs, by removing duplicate fees or selecting a provider with lower fees than your current ones. 

Consolidation may not necessarily be a good option for you, however. The main drawback to consider is the loss of valuable benefits from your existing scheme/s

Please see our Guide to pension consolidation for more information, including the pros and cons of consolidating multiple pension pots into one scheme. The government-backed Money Helper website also has useful information about consolidation. You may also wish to seek specialist guidance or advice before making a decision.

Purchasing an annuity from a defined contribution fund

Do you have a defined contribution pension scheme and want to explore your options for purchasing a guaranteed retirement income?As the UK’s leading annuity broker*, our specialist team at Retirement Line offers a full annuity information, quotation and arrangement service. 

To speak to an annuity specialist call the Retirement Line team today on 01733 973038 or request a free call back here.