By: Tim Bennett
15.11.2019
15.11.2019
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Pension basics (2019) – defined contribution schemes
Defined contribution (DC) pensions (a.k.a. “money purchase plans”) were once fairly rare but are now becoming standard for many employees. Since they work rather differently to the defined benefit (DB) schemes they are tending to replace these days, here is a quick tour of all the basics for anyone who is confused by the jargon.
Background
The reason why DC schemes have grown in popularity amongst employers is simple – they are more predictable and usually cheaper to run. In effect, they transfer risk from employer to employee (see below). This is, in many cases, not good news for employees.
Terminology
The reason why DC schemes are labelled as such is that the level of contribution, from an employer and employee, is fixed, usually at a percentage of monthly salary. That gives employers certainty about the ongoing payroll cost of running these schemes. However, the size of the eventual retirement benefit is unknown since it is dependent on many factors, including the employee’s and employer’s level of contributions, investment returns and inflation. As such, these schemes are also known as money purchase plans since you are quite literally putting money in now to (hopefully) buy more later with no guarantee about the final amount.
Basic mechanics
The way a DC scheme works is shown diagrammatically here;
Money paid in on the left (above) will hopefully grow (this is not guaranteed since it is linked to uncertain investment returns), aided by tax relief, minus the charges incurred to run the scheme. The size of the pot on the right (above) is unknown until the point where an employee decides to stop contributing and/or start to make withdrawals.
This is very different to a defined benefit scheme, where the final income stream is guaranteed, regardless of the level of contributions made by an employee. Any shortfall that arises is made up by an employer.
Key features
People with more than one type of pension, gained from working at different employers, need to understand the core differences between the benefit they may receive from a DC or DB scheme. This also matters when it comes to weighing up a transfer offer from one type to the other (a topic covered in more depth elsewhere).
Other key differences exist around the retirement date, with DB schemes often not paying out until an employee reaches 60 or 65. DC schemes, on the other hand, can start paying out from the age of 55 (this is set to rise in the future). Meanwhile, whilst the DB retirement benefit is pretty clear – a percentage of your final, or average, salary paid indefinitely – with DC schemes you are faced with several choices, from buying an income stream (called an annuity) to flexibly drawing down income and capital. You can even leave the scheme untouched if, for example, you have other sources of income to draw on first.
The good news
Whilst many employees rue the day their employers stopped offering a DB scheme, DC plans do have their upsides in terms of the control you have over the investment approach and benefits taken, the age at which you could start withdrawing funds and the ability to pass your pension assets onto future generations. This last point will be covered in more detail elsewhere but in summary, whereas DB assets cannot be inherited, DC assets can be under certain circumstances.
However…
The flipside of all this extra flexibility is a fundamental flaw with DC schemes – you could run out of money in retirement. That can happen for several reasons – you may simply fail to save enough on the way in and/or mismanage your withdrawals on the way out. DC funding is therefore an area where good advice can be crucial. Other downsides include the fact that there is no statutory backup scheme, should a provider go bust, and the onus to get the investment and withdrawal strategies right falls on your shoulders unless you seek help.
To find out more
Feel free to email on [email protected] or contact an Adviser to discuss any of the issues raised here in more detail.
