Defined contribution pensions

Employers offer two main types of pension: defined benefit (such as final salary schemes) and defined contribution, also known as money purchase schemes.

Until recently, defined benefit schemes were far more common. They promise the member a set annual income in retirement, based on the number of years’ service and the salary when the employee left the company. For example, if your final salary is £45,000 and you have accrued 1/60th of your final salary for 20 years, you receive a pension of £15,000 (i.e. £45,000 multiplied by 20 divided by 60). This amount will typically rise in line with inflation.

In these cases the employer bears the risks of long life expectancy and investment performance. As a result, many employers have closed defined benefit schemes to new members (and in some cases to existing members too), and replaced them with defined contribution schemes which transfer all these risks to the employee.

This is only an issue for employees of companies and charities. Public sector workers are still entitled to final salary pensions.

What is a defined contribution scheme?

A defined contribution, or DC, scheme takes contributions from the employer and employee and invests them over the long term to build up a pot of money to fund the employee’s retirement.

What is a typical contribution?

The employer’s contribution is normally bigger than the employee’s, and both are calculated as a percentage of salary. The National Pension Saving Scheme proposed by Lord Turner suggests a 3 per cent employer contribution. But Richard Meek, a principal at Punter Southall Financial Management, says this is “a poor level”. Schemes which replaced defined benefit pensions tend to be more generous. A fairly generous scheme may offer a 10 per cent employer contribution with a 5 per cent employee contribution. Some employers offer higher contributions for older employees, but new rules against age discrimination may put a stop to this.

How is the money invested?

Scheme members can sometimes choose from a menu of funds: actively and passively managed equity funds, commercial property funds and bond funds. As you near retirement, it is standard practice to reduce your exposure to riskier investments such as equities and shift into safer assets such as bonds or cash. Many DC schemes may only have one investment choice – a “balanced managed” fund – which will spread your investments across a range of asset classes.

What if I don’t know what I should invest in?

Many schemes offer a default asset allocation, which usually starts with most or all of your money invested in equities, and moves more money into bonds as you get older.

How much do I need to save?

The earlier you start saving, the less you need to put aside each year. Your scheme provider should give you projections of how much you will have to live on in retirement, based on your age, contribution level and the amount you have already saved.

Can I make extra contributions?

Yes, you can make virtually unlimited additional voluntary contributions (AVCs), or top-ups. “Anyone who can afford it should do AVCs,” says Meek at PSFM. “It costs far more to catch up later.” AVCs may be invested in the same way as the main contributions, although you may also be given a choice of different funds.

Can I take the money out before I retire?

In practice, no. You need to ask for permission from the scheme’s administrator, and you may not get it. If you are allowed to take some or all of the money out of your pensions savings, you will be hit with an “unauthorised payment charge” amounting to about half of the sum you withdraw.

What is the tax situation?

In order to encourage pension savings, the government grants tax relief on your contributions at your highest rate of income tax. So if you are subject to the top rate of income tax of 40 per cent, you will only sacrifice £60 of take-home pay for every £100 you put into your pension fund.

Your fund will have to pay some tax on dividends from equity investments, but will not be subject to capital gains tax. Once you start receiving your pension it will be subject to income tax, but you can take a tax-free lump sum of 25 per cent of your savings on the day you retire.

What if I have more than one pension scheme?

You can keep these separately if you wish. But some advisers recommend consolidating all your DC pension savings into the scheme with the lowest charges.

Is there any alternative to my employer’s scheme?

You can set up a self-invested personal pension (Sipp), which you can use as a wrapper to invest in a much wider range of assets than those on offer in most DC schemes. However, not many employers will allow you to invest their pension contribution outside the official company scheme. But, following changes to the rules in April 2006, there is nothing to stop you putting any money accrued in AVCs into a Sipp.