Defined contribution (DC) schemes can be either a personal plan or an occupational pension scheme. These days, most occupational pension schemes are defined contributions schemes – especially in the private sector.
How DC Schemes work
A defined contributions scheme provides retirement income based on a built up pot of pension money. The pension pot is created through the accumulation of pension contributions (less any charges) which are paid by both the policyholder and where appropriate an employer. The contributions are invested in investment funds with the returns added to the fund. At retirement the policyholder can take out a tax-free lump sum from the accumulated pension pot and use the rest to buy an annuity to provide an annual income for life.
Unlike a defined benefit scheme where the amount of pension benefits are known from the outset, with a DC scheme that amount the holder can expect to receive on retirement as annual income will depend on:
• The amount of paid in by the employee and/or the employer (or policyholder in the case of personal pensions),
• The performance of the pension fund/s,
• The fees deducted by the provider, and
• The annuity rates used to convert the pension pot into annual pension income.
The burden of risk
In a defined contribution scheme the pension contributions are usually a fixed level. So, if investment returns are low it is up to the scheme member to make additional contributions to avoid their pension income being less than they had planned for their retirement.
Also if life expectancy increases, defined contribution scheme members will need a larger pension pot to provide for these additional years. Again they will need to monitor their pension pot and make sure their pension savings are on course for a comfortable retirement.
When a DC scheme member buys their annuity they can be affected by fluctuating annuity rates, which would affect the amount of pension income they receive.
Types of defined contribution schemes
• Personal pensions and self-invested personal pensions: These can be an ideal way for the self-employed and those without an occupational pension scheme to save for retirement.
• Occupational defined contribution schemes: These are now the most common form of company pensions and both the employee and the employer make contributions.
• Group personal pensions and group Sipps: These are individual personal or Sipp plans set up by employers for their staff and should have lower administration charges than an individual plan and possibly employer contributions.
• Money Purchase schemes: Another name for defined contribution schemes. The holder carries the risk of investment volatility and increased life expectancy.
• Nest: The soon to be launched National Employee Savings trust is a low-cost occupational DC pension scheme designed to get low-to-middle earners and their employer making pension contributions.
• Stakeholder pensions: Employers with more than five members of staff must offer these, though they do not need to make contributions.