Defined Contribution Pensions in the UK Explained [2024 Guide]

Defined contribution (DC) pensions are popular retirement savings plans in the UK.

Often used as a workplace or individual pension plan, a DC pension scheme:

• Offers flexible contributions and a range of investment options.
• Simplifies the process of transferring pension benefits from one employer to another.

• Is tax deductible since the money is deducted from gross pay.

Ready to find out more about DC schemes in the UK?

What Is a Defined Contribution Pension Scheme?

Defined contributions, or money purchase schemes, are retirement plans where contributions are invested in assets like stocks, bonds, and mutual funds.

In private DC schemes, individuals are solely responsible for making their contributions. However, employers must contribute to employee pension schemes in workplace pensions.

Although the amount contributed to the plan is predetermined, the final pension amount depends on:

• The total pension contributions made throughout the plan.
• The assets where those contributions were invested.
• The investment returns earned from those money purchase schemes.

Many workplace and personal defined contribution pensions are available in the UK.

But before we dive into that, let's understand how workplace and private DC pensions function.

This information is for general purposes only and should not be considered investment advice. Consult with a qualified financial advisor for personalised guidance before making investment decisions.

How Workplace Defined Contribution Plan Works in the UK

In a UK workplace pension or occupational pension scheme, the employer deducts a portion (minimum 5%) of the employee's salary before deducting income tax.

This is the employee’s contribution to the DC pension scheme.

The employer must also contribute a certain percentage of the employee's salary to the pension plan, with a minimum contribution of 3%.

For example, let's consider the workplace pension scheme below:

• Employee's monthly salary: £4,000
• Employee's contributions per month: 5% of £4,000 = £200
• Employer's contributions per month: 3% of £4,000 = £120

The total monthly contribution in this occupational pension scheme amounts to £320.

Types of workplace DC pensions: the group pension plan and the master trust pension (which we'll explain below).

How Private Defined Contribution Plan Works in the UK

Private defined contribution pensions in the UK allow individuals to contribute independently to their retirement savings plan.

These pension schemes are suitable for those who want greater control over their savings — especially in the absence of traditional employer-provided pensions.

We’ll explore private DC schemes like Self Invested Personal Pension (SIPP) and stakeholder pensions shortly.

4 Common Types of Defined Contribution Pension Schemes

The common types of DC pension schemes are:

1. Group Personal Pension

A group pension plan (aka a collective defined contribution pension) is a type of workplace DC pension scheme in the UK.

Employers set aside a portion of the employee's income (minimum 5%) into a pension fund.

Additionally, the employer may contribute 3% or more to the employee’s pension fund, increasing the overall retirement savings amount.

These plans offer several benefits, including:

• Automatic deductions for convenient savings.
• Professional investment management to optimise returns.
• Additional tax relief, as contributions are typically made on a pre-tax basis.

2. Master Trust Pension

Master trust pension schemes operate as a centralised pension pot, where contributions from multiple employers are consolidated and collectively managed.

A board of trustees is legally obligated to act in the best interests of the scheme members in this type of workplace pension scheme.

What is a trustee?

A pension scheme trustee is an independent guardian responsible for protecting the member’s funds and assets in the master trust.

They ensure the scheme operates effectively and secure members' benefits.

The Financial Conduct Authority (FCA) regulates contract-based schemes like group pensions in the UK, while master trusts fall under The Pensions Regulator (TPR) regulation.

3. Stakeholder Pension

A stakeholder pension is a private pension scheme in the UK that offers individuals a straightforward and affordable means to save for retirement.

These personal pension plans come with low charges, initially capped at 1.5% for ten years and 1% after that.

They’re mainly suitable for the self-employed or individuals without a workplace pension scheme.

The best part?

Contributions are flexible, allowing individuals to contribute according to their preferences and adjust them as needed.

4. Self Invested Personal Pension (SIPP)

A SIPP is a private pension plan with more diverse investment opportunities, potentially leading to higher returns.

Unlike other types of pension in the UK, SIPPs offer individuals complete control over how and where their money is invested.

But here’s the thing: SIPPs come with higher costs and risks and require active management.

If you’re considering a self invested personal pension, carefully evaluate your risk tolerance and seek guidance from financial advisers before making investment decisions.

4 Ways to Access a Defined Contribution Pension Fund at Retirement

In the UK, individuals can begin accessing their defined contribution pension plan from age 55 as of 2024. The age is set to increase to 57 in 2028.

Here are four ways to access your DC retirement fund:

1. Annuity

Individuals can use their DC pension savings to purchase an annuity, which provides a guaranteed income for the rest of their life or a specified period.

Annuities offer stability and security, ensuring a fixed retirement income stream.

2. Income Drawdown

With an income drawdown, pension savers can leave their DC pension pots invested and withdraw a flexible income as needed.

They retain control over the withdrawal amount while the remaining funds continue to be invested, potentially offering growth.

The catch?

The income received is not guaranteed and depends on investment performance.

3. Lump Sum

UK pension holders can take a portion of their pension saving schemes as a tax-free lump sum.

The maximum tax-free lump sum allowed is 25% of the pension. However, the remaining funds are taxable as ordinary income.

4. Mix and Match

This allows individuals to combine different access options to tailor their retirement strategy.

For example, you could use a portion of your pension for an annuity to cover essential expenses. At the same time, you can utilise the remainder for income drawdown, providing flexibility and potential growth.

What Are the Benefits of a Defined Contribution Pension Plan?

A defined contribution scheme offers several advantages, including:

• Flexibility: Individuals can determine the amount and frequency of contributions based on their financial situation and goals.

• Individual ownership: These plans grant individuals ownership and control over their pension saving schemes, empowering them to make decisions about investment and management.

• Growth potential: Individuals can actively participate in investment decisions, diversify their portfolios, and adapt to market conditions — maximising the potential for long-term growth in their DC pension pots. Additionally, employers can match the amount of money an employee contributes to their account up to a specific limit, doubling the pension pot.

• Portability: A DC scheme allows individuals to transfer their pension savings to a new plan or keep them in the same plan when they change jobs, making it easy to switch employers.

• Lower fees and tax relief: Fees in DC schemes are generally lower due to a more extensive participant base. Moreover, contributions to the pension are deducted from gross pay, providing the advantage of being tax-deductible instead of being deducted from net pay.

What Are the Drawbacks of a Defined Contribution Pension Plan?

While participating in a defined contribution pension scheme offers many benefits, it's essential to be aware of potential drawbacks:

• Investment risk and market volatility: Poor investment decisions or market downturns can negatively impact the pot of money. Fluctuations in the financial markets can also lead to significant declines in the fund's worth.

• Self-management: Individuals monitor and manage pension investments in specific DC schemes like SIPPs. This can be challenging for those with limited investment knowledge or who prefer a more hands-on approach.

6 Defined Contribution Scheme FAQs in the UK

We’ll answer some common questions on this popular retirement savings option:

1. Defined Benefit Vs. Defined Contribution Pensions: What’s the Difference?

Here’s a quick comparison between defined benefit and defined contribution pensions:

A. Defined Benefit Pension

• The retirement benefit is predetermined and fixed.
• Based on factors like final salary, years of service, and a formula.
• Employers bear the investment and longevity risk.
• Typically, employers contribute a more significant portion.
• Not easily portable; tied to specific employers.

B. Defined Contribution Pension

• The contributions are fixed, but the retirement benefit varies.
• Based on the investment performance of the individual's contributions.
• Individuals bear the investment and longevity risk.
• Both employer and employee can make equal contributions to the plan.
• Highly portable; it caters to pension transfer between employers.

You could opt for defined benefit pensions to secure a guaranteed retirement income tied to salary and service. Alternatively, consider DC pension schemes for increased control over contributions, investment choices, and potential growth.

Here’s the interesting part:

In 2023, the UK saw a growing interest in Collective Defined Contribution (CDC) pension schemes, which aim to provide a middle ground between defined benefit and defined contribution plans (Source: Aon Corporation).

2. What Is a Local Government Pension Scheme?

The local government pension scheme (LGPS pension) is among the UK's largest funded defined benefit pension schemes.

It caters to employees in local government and participating employers.

Under the LGPS pension scheme, employees contribute roughly one-third of the costs, while employers cover the remaining expenses to provide LGPS benefits.

3. What Is the UK State Pension?

The State Pension is a regular government payment received upon reaching the State Pension age in the UK.

Individuals with additional income sources, such as a workplace or personal pension, remain eligible for State Pension. The pension amount depends on the number of 'qualifying' years of National Insurance payments.

Learn more about the UK State Pension — eligibility, pension amount, etc.

4. What are Additional Voluntary Contributions?

Additional voluntary contributions (AVCs) are extra contributions individuals can make to their occupational pension scheme, regardless of whether it’s in the public or private sector.

5. What Happens to the Defined Contribution Funds After The Individual’s Demise?

If a beneficiary has been designated, the investment fund can be transferred to them.

If no beneficiary has been assigned, the fund can be disbursed as lump sum payments to the individual's estate or used to purchase an annuity for surviving spouses or dependents.

The specific regulations and options may vary. Consult your pension provider or financial advisor for accurate information and guidance.

6. How to Retrieve the Account Information of a Defined Contribution Pension?

To retrieve account information for a DC scheme:

• Contact the pension provider directly: If you know the name of the pension provider or insurance company, contact them. They can help verify the account's existence and offer guidance on accessing the pension pot.

• Get in touch with previous employers: Contact your former employers to inquire about the pension scheme associated with your employment. They can provide information about the pension provider or insurance company and guide you on locating and accessing your pension account.

• Use pension tracing services: Contact the Pension Tracing Service, a free UK government service. You can reach them at 0800 731 0193 or use their online directory. This can assist in tracking down any lost or forgotten pensions.

Easily Administer Defined Contribution Pension in the UK With Kota

As an employer, offering DC pension schemes to your UK team can be challenging due to complex regulations and paperwork.

That's where Kota comes in.

Kota is a retirement benefits app that offers a digital-first pension for modern teams.

By partnering with Smart Pension, a leading workplace pension provider in the UK, we provide a straightforward platform for businesses to:

• Automatically enrol eligible employees in comprehensive DC plans.
• Set up employer contributions from the required minimum of 3% to up to 8%.
• Postpone auto-enrolments and manage re-enrolments.
• Proactively navigate regulatory changes.
• Integrate pensions with your human resources (HR) and payroll systems.

The result?

You ensure compliance and enable a streamlined experience for your workforce.

Sign up for Kota and enrol your team — it only takes a few minutes!