Defined contribution pension schemes
With a defined contribution pension, you build up a pot of money that you can then use to provide an income in retirement. Unlike defined benefit schemes, which promise a specific income, the income you might get from a defined contribution scheme depends on factors including the amount you pay in, the fund’s investment performance and the choices you make at retirement.
Defined contribution pensions build up a pension pot using your contributions and your employer’s contributions (if applicable), plus investment returns and tax relief. If you’re a member of the scheme through your workplace, then your employer usually deducts your contributions from your salary before it is taxed. If you’ve set the scheme up for yourself, you arrange the contributions yourself.
The fund is usually invested in stocks and shares, along with other investments, with the aim of growing it over the years before you retire. You can usually choose from a range of funds to invest in. Remember though that the value of investments can go up or down.
The size of your pension pot and amount of income you receive when you retire will depend on:
• How much you pay into your pot
• How long you save for
• How much your employer pays in (if a workplace pension)
• How well your investments have performed
• What charges have been taken out of your pot by your pension provider
• How much you take as a cash lump sum
• The choices you make when you retire
• Annuity rates at the time you retire – if you choose the annuity route
When you retire, your pension provider will usually offer you a retirement income (an annuity) based on your pot size, but you don’t have to take this and it isn’t your only option.
Defined benefit pension schemes
A defined benefit pension scheme is one where the amount paid to you is set using a formula based on how many years you’ve worked for your employer and the salary you’ve earned rather than the value of your investments. If you work or have worked for a large employer or in the public sector, you may have a defined benefit pension.
Defined benefit pensions pay out a secure income for life, which increases each year. They also usually pay a pension to your spouse or registered civil partner and/or your dependants when you die.
The pension income they pay is based on:
• The number of years you’ve been a member of the scheme – known as ‘pensionable service’
• Your pensionable earnings – this could be your salary at retirement (known as ‘final salary’), or salary averaged over a career (‘career average’) or some other formula
• The proportion of those earnings you receive as a pension for each year of membership – this is called the ‘accrual rate’, and some commonly used rates are 1/60th or 1/80th of your pensionable earnings for each year of pensionable service
These schemes are run by trustees who look after the interests of the scheme’s members. Your employer contributes to the scheme and is responsible for ensuring there is enough money at the time you retire to pay your pension income.
Check your latest pension statement to get an idea of how much your pension income may be. If you haven’t got one, ask your pension administrator to send you one. Statements vary from one scheme to another, but they usually show your pension based on your current salary, how long you’ve been in the scheme and what your pension might be if you stay in the scheme until the scheme’s normal retirement age.
If you’ve left the scheme, you’ll still receive a statement every year showing how much your pension is worth. In most cases, this pension will increase by a set amount each year up until retirement age. Contact your pension administrator if you’re not receiving your annual statement.
When you take your pension, you can usually choose to take up to 25% of the value of your pension as a tax-free lump sum. With most schemes, your pension income is reduced if you take this tax-free cash. The more you take, the lower your income. But some schemes, particularly public sector pension schemes, pay a tax-free lump sum automatically and in addition to the pension income.
Make sure you understand whether the pension shown on your statement is the amount you’ll get before or after taking a tax-free lump sum. Also, don’t forget that your actual pension income will be taxable.
Most defined benefit schemes have a normal retirement age of 65. This is usually the age at which your employer stops paying contributions to your pension and when your pension starts to be paid. If your scheme allows, you may be able to take your pension earlier (from the age of 55), but this can reduce the amount you get quite considerably. It’s possible to take your pension without retiring.
Again, depending on your scheme, you may be able to defer taking your pension, and this might mean you get a higher income when you do take it. Check with your scheme for details.
Once your pension starts to be paid, it will increase each year by a set amount – your scheme rules will tell you by how much. It will continue to be paid for life. When you die, a pension may continue to be paid to your spouse, registered civil partner and/or dependants. This is usually a fixed percentage (for example, 50%) of your pension income at the date of your death.
You may be able to take your whole pension as a cash lump sum. If you do this, up to 25% of the sum will be tax-free, and the rest will be subject to Income Tax.
You can usually do this from age 55 (or earlier if you’re seriously ill) and in the following circumstances:
• You can take the whole of your pension as cash if the total value of all your pension savings is less than £30,000
• You can take your pension as cash if it’s worth less than £10,000, regardless of how much your other pension savings are. You can do this for up to three different pensions
Will your pension income last for the rest of your life?
Following the biggest reforms to pensions in recent times, whilst the ability to unlock pension pots is attractive you also need to understand the tax implications of doing this and accept the risk of ensuring that the funds built up are managed effectively to ensure that they last for life. To discuss your situation, please contact Admiral Wealth Management on 01472 357035 or email firstname.lastname@example.org – we look forward to hearing from you.