What is a defined contribution pension?

How do defined contribution pensions work?

When you pay money into your defined contribution pension plan, it’s invested on your behalf. The amount of control you have over how it’s invested depends on your pension type.

In most workplace pension schemes, your contributions are automatically invested into what's known as a default fund. This is a carefully selected investment option designed to suit a broad range of savers, especially those who prefer not to make active investment choices. They aim to balance growth with risk and often adjust over time to become more cautious as you approach retirement. While they’re a solid starting point, you may be able to explore other funds if you’d like to tailor your pension to your personal goals.

With most types of pension you’ll be choosing between a range of investment funds. With a Self Invested Personal Pension (or SIPP) you can choose where your money is invested.

When you pay into your DC pension, you’ll get a little help:

• If you're eligible for automatic enrolment, your employer will contribute at least 3% of your qualifying earnings, while you contribute 5%, making a total minimum of 8%. To be eligible, you’ll typically need to be earning between £6,240 and £50,270 a year before tax. If you earn less than £520 a month, your employer isn’t required to contribute— but you can still choose to join the scheme and make contributions yourself If you’re not sure how your employer might top up your payments, check with them. 
• If you’re paying into any kind of  pension, you’ll get tax relief on the money you invest, on up to 100% of your annual earnings. Depending on the type of pension scheme you’re in, you’ll either get it automatically or have to claim it back yourself.

You can start taking money out of your DC pension pot once you’re 55 (or 57 from April 2028). You can usually take up to 25% of your pot as a tax-free lump sum, subject to the availability of any allowances. If you take any more, you’ll have to pay income tax on it.

Whether or not you take your lump sum, you’ll need to decide what to do with any money still invested in your pot.

You can take your money out:

• As cash
• By buying an annuity, which will give you a guaranteed income for life or a fixed period
• By opting for drawdown, to take out however much you need whenever you need it
• As smaller lump sums

All of this is quite a big contrast with DB pensions. They’re only ever set up for you by an employer. You often don’t have to pay into them and you’ll get a guaranteed amount from them, usually based on your final salary and length of service.

You won’t have any choice over how your money is invested and how much you can take out. You probably will be able to choose when it starts paying out, but if you decide to retire early, and your scheme supports this, the amount of pension income you receive will be reduced.

What are the advantages of a defined contribution pension?

• You can choose where your money is invested
• If you're in a workplace pension scheme your employer will contribute too
• You have more ways of taking your money out of your pot
• You can usually start taking it out at a younger age (55 or 57 as opposed to 60 plus)
• You have more flexibility around what to do with it when you die

What are the disadvantages of a defined contribution pension?

• Any money that goes into your pension is invested, which means that its value can go down as well as up – you might get back less than you put in
• Because your retirement income is based on how well your investments do, it’s you rather than your employer who’s taking the investment risk
• Unless you buy an annuity, your income from your DC pension isn’t guaranteed and could run out

Can you have both a defined contribution and a defined benefit pension?

Yes – in fact, you can have several of each at once.

With each new employer you’ll become a member of a new pension scheme, which could be either a DB or DC one. You might even end up with a hybrid pension that combines the benefits of both types of pension. You’ll probably only be paying into one pension scheme at any given time, though.

You can also save into either or both alongside other kinds of investment. Oh and, once you’ve got several different jobs on your CV you’ll probably also have several different pensions up and running. It can be difficult to keep track of them all. 

Want to learn more about bringing your pensions together?

Visit our MyFutureNow page to learn how finding lost pots and bringing them together can help you manage your pension and might save you money on fees.

How much to contribute towards your defined contribution pension?

There’s no single answer to that question because it depends on many different factors, including:

• How much money you’ve got coming in and what your outgoings are
• What sort of retirement lifestyle you’d like to save for – the Retirement Living Standards website can help you learn more about that
• How much you’ve already saved and how long until you retire

What happens to your defined contribution pension when you die?

When you die, you can leave any money in your DC pension pot to one or more beneficiaries. Currently your pension isn’t treated as part of your estate, so it won’t count towards any inheritance tax calculations. From April 2027, pensions will be part of the estate for IHT and potentially taxable.

If you die before the age of 75, any death benefit payments will normally be free of income tax provided the benefits paid under this plan and any other pension you have don’t exceed your available Lump Sum and Death Benefit Allowance. The allowance is normally £1,073,100 (unless you have a protected allowance), although any tax-free money you’ve already taken out will be subtracted from it.

If you die once you’re 75 or older, any payment money will normally be taxed as income at your dependent or beneficiary’s highest rate of income tax.