Building up a pot of money that can be used to provide an income in retirement
With a defined contribution pension, the member builds up a pot of money that they can use to provide an income in retirement. Unlike defined benefit schemes, which promise a specific income, the income the member might get from a defined contribution scheme depends on factors including the amount they pay in and the fund’s investment performance.
How defined contribution schemes work
Defined contribution pensions build up a pension pot using the members and their employer’s contributions (if applicable), plus investment returns and tax relief.
If they are a member of the scheme through their workplace, then the employer usually deducts contributions from their salary before it is taxed. If they have set the scheme up for themselves, they arrange the contributions themselves.
The fund is usually invested in stocks and shares, along with other investments, with the aim of growing it over the years before the member retires. They can usually choose from a range of funds to invest in. It’s important to also remember though that the value of investments can go up or down.
Commencing from 6 April 2015, a qualifying member will be able to access and use their pension pot in any way they wish from age 55.
They will be able to:
Withdraw up to 25% tax-free
Convert some or all of the remaining amount into a regular retirement income (known as an ‘annuity’), and/or
Withdraw the remaining cash in stages or as one lump sum, subject to tax at their highest rate
Between 27 March 2014 and 6 April 2015, interim rules apply that give more choice than before about how much of the member’s pension pot can be cashed in.
The size of the pension pot and amount of income received at retirement will depend on:
How much is paid into the pot
The length of saving
How much the employer pays in (if a workplace pension)
How well the investments have performed
What charges have been taken out of the pot by the pension provider
How much is taken as a cash lump sum
Annuity rates at retirement – if the annuity route is chosen
Any other type of retirement income chosen