Planning for your retirement is all about knowing what pension options are available to you and creating a strategy that suits your unique needs. A defined contribution pension plan is one of the most popular schemes available, so let’s explore it in further detail.
What is a defined contribution pension plan?
Defined contribution pensions can be set up independently with a private pension provider or by an employer. Nevertheless, professional guidance is advised, as your pension should be matched to your tolerance to risk and unique needs.
The amount that these pensions pay out essentially depends on how much you contribute towards the plan, how well your investments perform, and how long you spend contributing towards your pot.
Types of private pension schemes
Generally speaking, there are two types of private pension schemes: defined contribution pensions and defined benefit pensions.
Nowadays, employers will generally provide new employees with qualifying defined contribution schemes, but there may be some people who still hold legacy defined benefit schemes. These are also referred to as ‘average salary’ pensions, as you receive a guaranteed retirement income dependent on your past salary and how long you’ve worked for the employer. However, defined benefit schemes no longer exist for new contributors.
Adversely, the total pot in defined contribution pensions is dependent on a wide range of factors. You’ll need to consider how much you contribute, how frequently you contribute, whether your employer contributes, how well your investments perform, and how you choose to access your pension pot.
What’s the difference between a defined contribution and defined benefit pension?
Overall, the main difference between a defined benefit pension vs defined contribution pension is that the former guarantees you a fixed income and the latter is dependent on the total amount you pay in and the performance of your investments.
However, it’s worth noting that employers never offer defined benefit pensions nowadays as they are no longer available. Therefore, most individuals will have a defined contribution pension which can offer more flexibility.
The benefits of a defined contribution pension
There are various advantages to the defined contribution pension scheme, more specifically:
- You have higher flexibility when it comes to accessing and withdrawing your funds
- You can contribute until the age of 75 and make the most of the tax relief benefits
- Your family members can inherit your pension when you pass away
The downsides of a defined contribution pension
Like any pension scheme, a defined contribution pension will have a few downsides, more notably:
- Your pension pot can run out and an annual income is not guaranteed unless you save up adequately
- Your pension pot is dependent on the performance of the stock market and vulnerable to market downfalls.
- You are unable to access any funds until you are aged 55 or higher
- Only the initial 25% you withdraw from your pension is tax-free, the rest will be taxed as income
Defined contribution pensions can be a complex topic, so below we have listed a few commonly asked questions:
What makes a good defined contribution pension scheme?
The best kind of defined contribution pension scheme has minimal management charges, low transfer fees, and additional benefits.
How much should I be contributing to my defined contribution pension?
It’s up to you how much you want to contribute, however, the more money you contribute towards your pension pre-retirement, the more you will accrue in your final pension pot. As a general rule of thumb, between 10% to 15% of your annual income should go towards your pension.
However, you can’t contribute more than you earn in a year and there is a pension contribution cap of £40,000 PA. Similarly, all pension holders are subjected to a Lifetime Allowance, which is the maximum amount you can contribute towards your fund before getting hit by high taxes.
Can I move a defined contribution pension?
Yes, there should be no issues when it comes to transferring funds across defined contribution schemes, but it’s important to check for specific restrictions with your provider and weigh up the pros and cons of losing any benefits.
Can I add funds to a defined contribution pension pot?
Of course, it’s important to maximise your pension, just make sure you contribute within the guidelines outlined by your pension provider.
What happens when a defined contribution pension provider goes bust?
Don’t worry, most pensions in the UK are protected by the Pension Protection Fund (PPF). If your pension provider goes bust, and you’ve already started accessing your funds, you’ll be awarded 100% of the compensation you are entitled to. Having an expert by your side can ensure you select robust schemes and benefit from performance monitoring. If the professional believes your scheme is in jeopardy, you can switch to another.
Can you increase the contribution of your defined pension pot?
Most schemes will let you increase or decrease your monthly contributions to a level that you feel comfortable with.
How do I know if my pension is defined benefit or defined contribution?
The best way to know what kind of pension plan you hold is by asking a professional to assess it for you.
There is no understating the importance of retirement planning and maximising your future financial opportunities. Apart from the major tax benefits, the most important advantage of a defined contribution pension plan is that you can decide how much money you would like to save for your future.
You can make your pension part of your estate planning strategy so family members will inherit your legacy if you were to pass away. Plus, you have higher flexibility when it comes to withdrawing your funds. When it comes to retirement planning, it’s crucial to know the ins and outs of your options.
Still need further retirement planning advice? Efficient Portfolio works alongside a wealth of professionals that can provide the advice you need. Contact us today and a member of our team will be in touch shortly.