As Defined Contribution (DC) pensions overtake Defined Benefit (DB) pensions (in terms of money paid into schemes) for the first time ever, increasingly people are taking an interest in how the two differ and the relationship between them. The Office of National Statistics has reported that in 2018, employee contributions for DC pension pots reached £4.1bn, compared to the £3.2bn that employees contributed to DB schemes.
With April 2019’s increase to minimum contributions for auto enrolment pension schemes seeing employer contributions hitting 3% and employees contributing 5% towards their pension, the trend of DC increases in relation to DB isn’t set to slow any time soon.
So before DB pensions become a distant memory, let’s take a look at exactly what they are. A DB pension, which is sometimes referred to as a final salary scheme, promises to pay you a guaranteed income, for life, once you reach the schemes normal retirement age. Usually, the payout is based on an accrual rate (a fraction of your final salary), which is then multiplied by the number of years you’ve been a scheme member.
A DC scheme is different from a DB scheme in that your payout is calculated by your and your employer’s contributions, and is dependent on how those contributions perform as an investment and the decisions you make upon retirement. Your pension pot is usually invested in stocks and shares while you work, although some schemes automatically switch your investments into less risky assets as you get closer to your retirement date (a process known as lifestyling). There is a level of risk, as with any investment, but the goal is to see your pot grow!
Upon retirement, you have a decision to make with how you access your pension pot. Typically, you can take the whole fund as a lump sum, with 25% being tax free. Alternatively, you can take lump sums from your fund as and when you wish. You can also take 25% of your fund tax free, receiving the remainder as regular taxable income for as long as it lasts, or take the 25% and convert the rest into a guaranteed income for life.
One of the reasons for DB schemes becoming scarcer is that higher life expectancies mean employers face higher unpredictability and thus riskier, more expensive pensions. This is a trend that looks likely to continue. If you’re unsure of how to make the most of your retirement nest egg, it’s recommended to consult with a professional.
A pension is a long-term investment. The fund value may fluctuate and can go down which may impact on the level of pension benefits available. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future. Occupational pensions are regulated by The Pensions Regulator.
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