What is a defined contribution pension?

Money purchase pensions explained

Defined contribution or money purchase pensions are a broad range of products which you use for saving money towards a retirement income.

DC pensions can either be arranged by you personally – usually known as a private pension – or by your employer. A private pension involves no contributions from an employer, while both the employer and the employee contribute to an employer defined contribution pension.

How much is a defined contribution pension worth?

The value of your money purchase pension scheme – and therefore to some extent the size of your retirement income – depends on your contributions to the plan and the fund’s investment performance.

Be aware that your defined contribution pension scheme could rise and fall in value along with the markets because it depends on the investment performance of the underlying funds.

How much your pension is worth will also depend on number of other factors, including:

• How much your employer and/or you contribute
• How long you save for
• Any charges deducted by your pension provider.

Difference between defined contribution and defined benefit pensions?

Your dad probably has a final salary pension or defined benefit pension, which you have to be invited into by your employer. They offer a guaranteed income for life after retirement. There are no such guarantees with a defined contribution pension, which are currently most people’s only option for pension saving given the decline in DB schemes.

What do I do with my pension pot to buy a retirement income?

There are a number of options available for turning your DC pension pot into a pension income. Once you hit the age of 55, you’re able to access this pot of money to buy a retirement income. Your options include:

• Buying an annuity, where you enter into a contract with an insurance company that agrees to pay you an income for life in exchange for your pension cash
• Entering into income drawdown, which allows you to take an income from your pension pot; you can take as much or as little as you want, when you want
• Taking a cash lump sum and/or take some or all of the pension pot and invest it in another way to provide an income.

You can take the first 25% of your pension pot as a tax-free cash lump sum, with the remainder being taxed by HMRC just like any other income. This will be taxed at your highest marginal rate, so be careful you’re not pushed into a higher income tax bracket by withdrawing cash from your pension.

You’ll also have to think very carefully with regards to how long you think you’ll live and how much income you’ll need for the rest of your life. If you choose not to purchase an annuity, the pot of money from a defined contribution pension scheme can run out.