A defined contribution, also known as a money purchase pension, is the most common type of workplace pension, where your contributions are invested in the stock market and the amount you receive when you retire is based on underlying investment performance, in addition to employer contributions.
Unlike defined benefit pensions (see below), they don’t provide a guaranteed income in retirement, and are considered less expensive for employers to run. However, the hope is that, over decades, you can benefit from investment growth and build a substantial pot.
How defined contribution pensions work
If you have recently been enrolled in a workplace pension, or work in the private sector, chances are, you’ll be paying into a defined contribution pension scheme. You’ll be automatically signed up by your employer if you are aged 22 or over and earn at least £10,000, unless you actively opt out of your employer’s pension scheme.
You will contribute a certain percentage of your salary each month into a workplace defined contribution pension. The amount you pay in depends on how much you have chosen to contribute, but under auto-enrolment, there’s a minimum percentage you must pay in.
How much will you pay into your workplace defined contribution pension?
Under auto-enrolment, you must pay 5% of your salary into your pension each month as a minimum, while your employer contributes 3%. That makes the total minimum contributions into your pension stand at 8%. You may choose to pay in more than the minimum amount, depending on your company pension rules.
Some companies, and particularly larger employers, may promise to match your contributions. In this case, your employer pays in the same amount as you, beyond the minimum percentage. It can be wise to save extra money into your pension to benefit from extra employer money, and you could think of it as benefitting from a pay rise that’s delayed until you reach retirement. Ultimately, if it’s an option and you can afford it, increasing your contributions may be worth doing to increase your pension provision.
Your contributions are usually put directly into your pension each month, so they are taken from your salary before tax. The amount that is paid into the pension is then topped up with tax relief. Effectively, this gives you back the money you would have paid in tax if you had received the money as salary. For basic-rate taxpayers, this means you get tax relief on the pension contributions at 20%. If you’re a higher-rate taxpayer, this rises to 40% and reaches 45% if you’re an additional-rate taxpayer. You can find out more in our article How pensions tax relief works.
Your money is invested in the stock market, and you may be able to choose between a variety of funds, or stick to your workplace scheme’s default fund. It’s worth checking your options, and considering how long you have to go until retirement and your attitude to risk, though, instead of relying on the default option.
What you receive at retirement from a workplace defined contribution pension
Here is a rundown of what affects how much you receive from a defined contribution, or money purchase pension:
How much your employer has contributed to your pensionHow long your pension has been investedHow the underlying investments have performed over this time
You can find out more about how defined contribution pensions work in our article What is a defined contribution pension?