A defined contribution plan is a type of pension based on the amount of money paid in to the scheme over time and the growth of the underlying investments. Payments into the plan can be made by an employer, a policy holder or both.
Defined contribution pensions enable savers to pay a portion of their wages into the plan and to invest the savings how they wish. Policy holders can also make personal contributions into their defined contribution pensions, using any surplus funds they have available. The pension plan provider invests money in line with the policy holder’s instructions. The value of the pension may go up or down depending on the performance of the investments. Holders of this kind of pension may be able to choose from a range of investment types offered by the provider and, as their goals and personal situations change, can alter their asset allocations—mixes of equities, fixed interest, cash and other assets.
The amount of income that policy holders can draw from the pension will depend on how much the fund has accumulated from contributions and investment growth by the time they retire. As such, it is not usually possible to guarantee how much income policy holders will receive from a defined contribution plan upon retirement.
Unlike many pension schemes, defined contribution plans may not have to be taken as a form of annuitised retirement income. Instead, they are essentially a type of tax efficient investment account that members can withdraw income from once they reach a prescribed age.
All employers in the UK must provide a workplace pension scheme and all employees who meet certain criteria must be enrolled.[i] This process is called auto-enrolment and could help more UK employees save and prepare for retirement. Many companies across the globe offer retirement savings vehicles for employees, but some plans are voluntary and don’t automatically enrol their company employees into the plans. In the UK, the hope is that auto-enrolment will help encourage employees to take control of their retirement savings.
Many workplace pensions are defined contribution pension plans, where there is a minimum contribution level for the member’s employer. A hypothetical example might be the employer and employee each contributing 5% of the employee’s earnings. Some schemes are flexible, allowing members to decide how much they wish to contribute at various periods, with the employer paying a defined contribution, sometimes referred to as a “contribution match.”
Do not confuse defined contribution workplace schemes with defined benefit pension schemes, though. A defined benefit scheme, as the name suggests, pays out a secure income for retirees. The amount of income or benefit provided is defined by the number of years the member worked for their employer, the scheme accrual rate and the salary earned while employed, rather than the amount they and their employer contributed to a plan.
Policy holders get tax relief from the government, meaning they may be able to pay less tax and grow savings tax free while they work. Pensions allow policy holders to take a tax-free lump sum from their pension pot which is one of the retirement benefits that can help to provide a tax efficient income in retirement.
However, every plan is different, so it is best to seek advice from the provider or a tax adviser about the specifics of your defined contribution plan.
Planning for retirement is crucial, and even if you’re near retirement, it’s never too late to start. The sooner you check out your options and take appropriate action, the more likely you are to achieve your long-term retirement goals. Suitable planning can go a long way towards building sufficient pension funds for a secure future.
Unfortunately, some investors do not take adequate steps to consider and plan their pensions and, as a result, have to work longer or sacrifice some aspect of their lifestyle or financial freedom in retirement.
Fisher Investments UK aims to help educate investors on the importance of saving and building a more secure future in retirement. To learn more about how Fisher Investments UK can help you, download one of our educational investing guides or contact us to speak with one of our experienced professionals today.
[i] GOV.UK, as of 14/9/2018. https://www.gov.uk/employers-workplace-pensions-rules.