Defined Contribution Pensions: How They Work & What You Need to Know

What is a Defined Contribution (DC) Pension?

A Defined Contribution pension is a type of workplace or personal pension where you, your employer, and the government (through tax relief) pay money into a pension pot that's invested in equities, bonds, or other assets on your behalf.

Unlike Defined Benefit pensions that promise a guaranteed income when you retire, DC pensions aren’t able to guarantee what you’ll get. Instead, the size of your DC pension payments will entirely depend on how much is paid in and how well your investments do.

In theory (and given enough time), your Defined Contributions pension pot could grow considerably over and above the amount you contribute, assuming your investments perform well. On the other hand, because DC pensions do rely on investment performance for some of their value, this type of pension carries the risk that your pension might fall in value if your investments struggle.

Why are Defined Contribution schemes so common now?

There are a number of reasons why private sector employers have increasingly replaced Defined Benefit pension schemes with Defined Contribution ones, but they can largely be summed up in two words: risk and cost.

Risk: Instead of taking on the risk that a pension fund will cover their employees’ guaranteed incomes for the rest of their lives, Defined Contribution pensions allow employers to define the amount they contribute to the employee’s pension, without being obligated to guarantee the amount the employee will receive after employment.

Cost: Since Defined Benefit pensions pose a higher risk to the employer, they have to contribute a larger portion of the employee’s salary to the pension fund each year in order to offset that risk. With a Defined Contribution pension, on the other hand, the employer can contribute a smaller percentage. In fact, employers often contribute as much as 15% to 25% of an employee's salary to a DB pension, whereas they can contribute as little as 3% to a DC one (although many do contribute more than that statutory minimum).

It’s also worth remembering that Defined Benefit pensions were the norm at a time when many employees had a ‘job for life’. Now that employees often have several (or, in some cases, dozens) of jobs during the course of their careers, the flexibility of DC pensions makes more sense.

How does a Defined Contribution pension work?

There are three key factors to consider when you’re trying to understand how Defined Contribution pensions work:

Contributions

Your DC pension can receive money from three types of sources:

Your own contributions: If it’s a workplace pension you’ll usually contribute a percentage of your salary, with the current auto-enrolment minimum being 5% of your salary (although only 4% actually comes from your pay, with 1% representing tax relief). If it’s a different type of DC pension then you’ll usually be able to set your own contribution levels.

Employer contributions: If your DC pension is a workplace pension then your employer must contribute at least 3% of your salary to it, although many employers contribute more to remain competitive or match your contributions up to certain levels.

Tax relief from HMRC: The government adds tax relief to your contributions, effectively topping up your pension pot. Basic rate taxpayers receive 20% tax relief automatically, while higher and additional rate taxpayers can claim additional relief by filing a self assessment.

It’s important to remember that there are annual limits to how much can be contributed tax-free, and this limit applies across all sources rather than just your own contributions. The standard Annual Allowance is £60,000 a year, although high earners may face a reduced allowance through tapering rules.

Investment growth

Your pension contributions are invested in a range of different investments, such as equities, bonds, property, and alternative assets.

The growth of your pension pot depends on how much is contributed and how these investments perform. Over long periods, diversified investment portfolios have often provided positive returns, but there are no guarantees with a DC pension and the value of your pot will fluctuate with market conditions.

Pension pot ownership

Unlike DB pensions, where you have rights to future income, with DC pensions you own an actual pot of money. This ownership brings both advantages and responsibilities:

• The pot is registered in your name and moves with you throughout your career.
• If you change jobs, you can transfer your pension pot to your new employer's scheme, keep it with your previous provider, or consolidate multiple pots with a single provider.
• You have investment choice (within the options your scheme provides) and can usually switch between different funds. Many people stick with default investment strategies, but you can take a more active approach if you prefer.

What are the Defined Contribution pension types?

There are quite a few different types of DC pensions, and they each have different features, investment options, and cost structures. Understanding these differences helps you choose the most appropriate option for your own retirement.

Workplace DC pensions

Since 2018 every employer in the UK has had a legal obligation to auto-enrol every eligible employee into a workplace pension scheme.

The main advantage of workplace pensions is mandatory employer contributions - employers have to contribute at least 3% of the employee’s salary to their pension, and many commit to contributing significantly more than that.

Employees also have to contribute at least 5%, although again many choose to contribute more in order to grow their retirement savings more quickly. 

Personal DC pensions

Personal Defined Contributions plans are schemes that run independently of your employer. There are a few types of private DC pensions:

• SIPPs (Self-Invested Personal Pensions): SIPPs are often considered the most flexible type of DC pension, because they allow the pension holder to choose their own investments. For that reason, they’re often chosen by people who are interested in the financial markets or have personal experience with investing.
• Stakeholder pensions: Stakeholder pensions are a type of private pension that was introduced by the British government in order to encourage more people to save for retirement. They’re designed to be very flexible and cost effective, with low fees and the flexibility to change when and how much you contribute.
• Standard personal pensions: Some traditional personal pensions offer a broader range of investment options than stakeholder pensions, but they sometimes have higher fees too. They usually don’t require the same level of investment decision making as a SIPP would require.

How much can you contribute to a Defined Contribution pension?

It’s important to understand how much you can contribute to your Defined Contribution pension, because there can be tax implications if you go over a certain amount.

Annual Allowance: The Annual Allowance is the maximum amount that can be contributed to all of your pensions combined in any given tax year before you might face a tax liability. It’s currently set at £60,000, but it’s important to remember that that amount doesn’t just cover your own contributions. It includes:

• Your employer’s contributions
• Tax relief
• Any third-party contributions

Tax relief operates on contributions up to 100% of your annual earnings or the annual allowance, whichever is lower. This means you can't get tax relief on pension contributions that exceed your annual salary.

Your contributions also can’t be higher than your full annual salary per year, so if you’re on a salary of £40,000 then £40,000 is the maximum that could be contributed even though the Annual Allowance is £60,000.

Tapered Allowance: If you’re a particularly high earner then your Annual Allowance might also be reduced through a process known as tapering. If the combination of your annual income and your employer’s contributions to your pension amount to more than £260,000, then your Annual Allowance would be tapered (i.e. reduced) by £1 for every £2 of income above that amount, down to a minimum of £10,000.

Carry Forward: If you’re earning a lot more now than you did in previous years then there’s another Annual Allowance rule to be aware of - ‘carry forward’. This rule allows you to use unused Annual Allowance from the previous three tax years, carrying it forward to this tax year in order to be able to contribute more to your pension without being liable for tax.

What are the advantages and disadvantages of a DC pension?

While DB pensions might be considered the ‘gold standard’ of retirement savings, Defined Contribution pensions are still an incredibly valuable way to save for retirement.

Advantages

• Flexibility: DC pensions are usually very flexible, with many of them giving you the flexibility to adjust when and how much you contribute. You’ll also have a lot of flexibility when deciding on your retirement date, and some of them (like SIPPs) will give you the flexibility to decide how the money is invested.
• Potential for Higher Growth: If your pension’s investments perform particularly well there’s the potential to end up with a much bigger pension pot than you (and your employer) contributed, particularly if the pension was set up early in your career and has been growing for 25 or 30 years.
• Pension Freedoms: Since a change to the pension rules in 2015 (known as ‘pension freedoms’), DC pensions have offered a lot more flexibility in how you access your pension after retirement. You’re now able to take 25% of it as a tax-free lump sum, withdraw retirement income as and when needed (known as flexible drawdown), or buy an annuity that offers you a guaranteed income.

Disadvantages

DC pensions aren’t perfect, and many financial advisers might argue they’re a lot less advantageous than a DB one. Some of the main disadvantages with this type of pension include:

• No guaranteed income: Unlike a DB pension, the size of your DC pension pot will entirely depend on how much you (and your employer) contribute, and how the investments perform.
• Investment Risk: If the investments don’t perform well, there’s the risk that you won’t get back much more than you contributed… or in some cases even less than was contributed, if the investments do particularly poorly.
• More Involvement: Some DC pensions require you to decide on the investments, but even if you don’t have to do that you’ll usually still have to be a bit more hands-on when it comes to monitoring performance, keeping an eye on fees, and deciding on whether or not you should move to a different provider.

How do I access a defined contribution pension?

The flexibility to access your DC pension is one of its key advantages, but you’ll need to understand your options.

Minimum age: You can usually access your DC pension from the age of 55 (rising to 57 in 2028). Some schemes may have higher minimum ages though, and access before the age of 55 is generally only permitted in exceptional circumstances like serious ill health.

25% tax-free lump sum: You can usually take up to 25% of your pension pot tax-free, subject to the lump sum allowance of £268,275. This doesn't have to be taken all at once though… you can take it in stages if you’d prefer, spreading the tax break out over time.

Flexible drawdown: After taking any tax-free cash, you can keep the remainder of your pension pot invested if you want, while ‘drawing down’ income from it as you need it.

What are pension freedoms?

The 2015 pension reforms made DC pensions much more flexible, giving pension holders the freedom to decide how and when to access their pensions, tailoring withdrawals to their specific needs and circumstances.

This does mean that there are sometimes additional tax implications though, because large withdrawals can push you into higher tax brackets.

How are defined contribution pensions taxed?

Understanding the tax implications of DC pensions throughout their lifecycle helps you maximise tax efficiency and plan effectively for retirement.

During accumulation: The tax benefits during the accumulation phase make pensions extremely tax-efficient savings vehicles:

• Contribution tax relief: You receive tax relief at your marginal rate on contributions
• Tax-free growth: Your pension pot grows free from income tax and capital gains tax
• No inheritance tax (for now): Pensions are currently outside your estate for inheritance tax purposes, although this is due to change in April 2027 when new laws will come into effect that will see pensions become subject to inheritance tax.

During withdrawal: The tax treatment when accessing your pension is more complex:

• 25% tax-free: Up to £268,275 can be taken as tax-free cash
• Remaining 75% taxable: Treated as income and taxed at your marginal rate
• No National Insurance: Pension income doesn't attract National Insurance contributions
• PAYE operated: Your pension provider deducts income tax before paying you.

Annual Allowance considerations: DC contributions are tested against your Annual Allowance each tax year. If you exceed your allowance and can't use carry forward, you'll face an Annual Allowance charge.

Money Purchase Annual Allowance (MPAA): If you take flexible benefits from your DC pension (other than just the 25% tax-free lump sum), your future annual allowance for DC contributions reduces to £10,000. This prevents recycling pension withdrawals back into pensions for additional tax relief.

How to manage your DC pension well

Effective management of your DC pension can often result in a bigger pot (although it’s by no means guaranteed).

Review investment options regularly

Many people stay in their scheme's default fund, which is usually a reasonable choice. Default funds typically use ‘lifestyle’ strategies that automatically reduce risk as you approach retirement. However, reviewing whether the default remains appropriate for your circumstances is worthwhile.

Track performance and adjust contributions

Check your pension statement at least annually, looking at things like contribution levels, fees, fund performance and projected retirement amount.

Consider consolidation

It might be worth considering merging old pension pots for simplicity and cost-saving, although it’s also important to weigh up things like the cost of closing an older pension, different fee structures etc.

Switch providers

If fees are high or performance is poor, you could choose to move your existing DC pension to a different provider.

As with consolidating, it’s important to take into account the cost of closing the pension you’re leaving, and any other differences in fee structures.

What happens to my Defined Contribution pension if I die?

DC pensions currently offer significant advantages for inheritance planning compared to many other investments, particularly regarding tax treatment and flexibility for beneficiaries.

Beneficiary Nominations: Most DC pension providers allow you to complete an 'expression of wish' or beneficiary nomination form specifying who should receive your pension pot. While providers aren't legally bound to follow your wishes, they usually do unless there are compelling reasons not to.

Keep your nominations updated after major life events like marriage, divorce, or births. Clear nominations help ensure your pension reaches your intended beneficiaries quickly without family disputes.

Tax Treatment: The tax treatment of inherited DC pensions currently depends on your age at death:

Death at 75 or younger:

• Tax-free inheritance: Your beneficiaries can inherit your entire pension pot without paying income tax
• Flexible access: They can take lump sums, set up drawdown, or buy annuities
• No time limits: Benefits can be paid at any time without affecting tax treatment

Death after age 75:

• Income tax applies: Beneficiaries pay income tax at their marginal rate on withdrawals
• No inheritance tax: Pensions remain outside your estate for inheritance tax purposes
• Flexible access: Same withdrawal options as death before 75

It’s important to note that this tax treatment is due to change in April 2027, when new laws will mean beneficiaries will be liable for both inheritance tax and income tax if you’re over the age of 75 when you die, or liable for inheritance tax but not income tax if you’re 75 or younger when you pass away.

Spousal and Dependant Options: Beneficiaries can usually choose how to access inherited pensions. There will be a few different options:

• Drawdown continuation: Keep the pension invested while taking income as needed, maintaining growth potential while managing tax efficiently.
• Lump sum inheritance: Take the entire pot as cash, useful for paying off debts, buying property, or investing elsewhere.
• Annuity purchase: Buy guaranteed income for life, providing security and certainty.
• Leave invested: Some beneficiaries choose to leave inherited pensions invested for future generations.

Common myths about DC pensions

“I’ll Have to Buy an Annuity”

This used to be the case, but since the 2015 pension freedoms you now have more options for your DC pension. While annuities remain an option and can provide valuable guaranteed income, you're not required to buy one. You can:

• Keep your pension invested and take income through drawdown
• Take lump sums as needed
• Combine approaches, using part of your pot for an annuity and keeping the rest flexible
• Do nothing until you need income

The choice depends on your personal circumstances, risk tolerance, and income needs.  

“It’s too risky to be in the stock market”

While stock market investments do involve risk, avoiding them entirely may be riskier for long-term pension saving. Consider:

• Inflation risk: Cash and low-risk investments may not keep pace with inflation over 20-40 year periods, reducing your buying power.
• Time horizon advantage: Young pension savers have decades to ride out market volatility, allowing them to benefit from long-term growth potential.
• Diversification benefits: Modern pension funds spread risk across thousands of investments, reducing the impact of any single company or sector performing poorly.
• Professional management: Pension fund managers have expertise and resources individual investors lack.

The key is choosing an appropriate level of risk for your age, circumstances, and comfort level, not avoiding all risk entirely.

“I can access my pension whenever I want”

While the 2015 freedoms provided much greater flexibility, there are still restrictions:

• Minimum age: You cannot access your pension before age 55 (rising to 57 from 2028) except in exceptional circumstances like serious ill health.
• Tax implications: Large withdrawals can push you into higher tax brackets, significantly reducing the net amount you receive.
• MPAA trigger: Taking flexible benefits reduces your future annual allowance for pension contributions to £10,000.
• Employer scheme rules: Some workplace schemes may restrict how and when you can access benefits while employed.

Understanding these restrictions helps you plan effectively and avoid unexpected consequences.

Frequently Asked Questions

Can I lose money in a Defined Contributions pension?

Yes, your DC pension pot can fall in value due to poor investment performance. Unlike cash savings accounts, pension investments can go down as well as up. However, over long periods, diversified investment portfolios have historically provided positive returns. The risk of losing money is balanced against the potential for growth that outpaces inflation – something cash savings often fail to achieve.

How is my DC pension invested?

Your pension contributions are typically invested in a range of funds chosen by your scheme's trustees or by you. Most people's pensions are invested in "default funds" that include a mix of shares, bonds, property, and other assets. These funds automatically adjust risk levels as you approach retirement, moving from higher-risk, higher-growth investments when you're young to more stable options as retirement nears.

Can I transfer my DC pension to another provider?

Yes, DC pensions are usually portable and can be transferred between providers. This might make sense if you find a provider with lower charges, better investment options, or superior service. However, check for any exit charges from your current provider and ensure the new provider offers suitable options for your needs before transferring.