Introduction to UK Defined Contribution Pensions
Pension Schemes That are Becoming Increasingly Common
Sep 13, 2009
Defined contribution pension schemes operate in the same way as most regular savings plans. The saver puts aside an amount of money, generally every month. This money is passed to a pension company that invests it, usually in the stock market.
It is called a defined contribution pension because the saver knows exactly how much they are putting into the scheme- their contribution- but they do not know how much money they will receive at retirement. This is very different from a defined benefit pension, where the amount of money a person receives is based on their length of service with an organization, and their final salary.
The uncertainty about the outcome of a defined contribution scheme is because no one can predict how much additional income will be generated through the investment in the stockmarket. As with all investments there is an element of risk, and the value of the pension plan may fall as well as rise from time to time.
Self invested pension plans, or SIPPS, give the individual more control over how their pension contributions are invested.
Pension Contributions Tax Relief
A major incentive for people to save through pension plans, rather than other types of savings plans, is the tax relief they receive. This means that if someone is a taxpayer and they make payments into a pension scheme, the government repays the amount of tax originally deducted from the amount being saved. This repayment also goes into the pension scheme.
So if a person in the UK is on a salary of, say, £30,000 a year, they will be paying tax at 20%. If they make a monthly payment into their pension scheme of £80, the government will refund £20 in tax, bringing the total being saved to £100. That's because when the person was paid £100 by their employer, 20% or £20 was originally deducted in tax.
If a person is a higher-rate taxpayer, paying tax at 40%, they would have £53.33 refunded.
While pension contributions tax relief is a major incentive to save for a pension, the income from a pension is taxable. So at some point in the future, tax will be paid on at least some of the income generated by the savings.
Employer Pension Contributions
Many employers also make pension contributions on behalf of their employees. The amount they pay is usually a percentage of salary and there is often a requirement that it is matched by the employee. So an employer may be willing make a contribution of up to 6% of a person's salary, as long as that person is also making a 6% contribution of their own.
This can be a useful way for employees to boost their income from their employers. The employee is being offered extra money, but on the condition that they make pension contributions.
Defined Contribution Pension Plans are Portable
Because a contribution based pension plan is directly linked to an individual, it can effectively be moved from employer to employer. Personal contributions can also be made without the employer's involvement, as long as they are within the rules of the plan and tax laws.
This means an individual can have more than one pension scheme operating through their lifetime. They may choose to run different types of scheme to spread their risk. It is possible, for example, to operate a self invested pension plan alongside a defined contribution pension plan.
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