What is a defined contribution pension?
Defined contribution pensions explained, including how they work and a comparison with defined benefit pensions.
The most common kind of pension today is what is known as defined contribution. In this article, we'll explain what that means and how defined contribution pensions work.
Defined contribution vs defined benefit
When it comes to life after work, there are two main types of pension plan you'll come across; defined contributions and defined benefit.
Put simply, defined contribution (sometimes shortened to DC) means the value of your pension comes from your contributions. The more you pay into your pot, the larger it will be.
This is in contrast to a defined benefit pension (DB). Here, the value of your pension comes from a fixed income paid by your employer, based on how long you've worked for the company. These days, defined benefit pension schemes are relatively rare.
How defined contribution pensions work
The value of a defined contribution pension scheme comes from how much you pay in and how your pension fund performs.
Defined contribution means the value of your pension comes from payments into your pot.
You can make regular contributions every month, one-off payments, or a combination of the two. If you have a workplace pension, your employer may also make contributions to your pension on your behalf.
Every time you pay in, you'll benefit from tax relief on your contributions. For basic rate taxpayers, this means a 25% bonus every time you pay in - essentially a refund on the 20% income tax you already paid.
It's a little complicated but the important thing is this: contribute £100 into a defined contribution pension plan and the government will add £25 as a tax bonus. If you’re a higher or additional rate taxpayer, you can claim further tax relief via your self-assessment tax return.
Finally, remember that your savings are invested in whichever pension fund you chose. The performance of your fund will affect the value of your pot. As with any investment, the value can go down as well as up.
Withdrawing from a defined contribution pension
You can start withdrawing from a defined contribution pension plan at 55 (rising to 57 in 2028). The first 25% is tax-free. You can withdraw it as a cash lump sum, take it in smaller chunks or withdraw a regular amount as an income. You could also use it to buy an annuity to provide a guaranteed income for life. Or you can do a combination of these options.
Remember, you may need to pay tax on your pension income, depending on how much you take out each year.