Back to Basics: How does a DC pension work?

What is a DC pension scheme?

Workplace pension schemes are broadly divided into two types – Defined Benefit (where we know what will be paid out but are uncertain about what the amount paid in will need to be) and Defined Contribution (where we know what has been/will be paid in, but don’t know precisely what will be paid out).

Defined Benefit – Flexible cost

Defined Benefit (DB) schemes are becoming quite a rare beast these days. They provide a benefit based on a number of factors – usually in the UK this means years of service and level of pay. Traditionally, this was pay immediately before retirement (hence the term ‘final salary pension’). Different approaches can apply for DB pensions abroad – for example, in Japan job grade and performance can be included in the formulas which determine what a member will receive.

Simply put, we know what is paid out – but what is required to be paid in can change at each scheme valuation, depending on a number of factors. This means that the scheme, and in turn the sponsoring employer, takes on all the risks.

Increasing costs for sponsoring employers have presented themselves over the past few years, due primarily to increased regulation, improving life expectancy and changes to funding requirements. This has resulted in many employers looking to move away from DB pension provision.

Defined Contribution – Flexible benefit

Defined Contribution (DC) schemes are far more prevalent in the UK now, and recent Office for National Statistics information shows that more employees are members of this type of pension than any other type. But what exactly is a DC pension scheme?

A simple answer would be to say that it is a later life savings plan built up through contributions (employee and employer), tax relief (be it through payroll or the pension plan) and investment returns. Contributions are paid at a set rate – normally expressed as a percentage of pay (in line with or exceeding auto-enrolment minimum levels). A range of investment funds is usually offered, into which members can see their money invested (many employers now use contract based pension schemes, with individuals having their own policy, which simply receives contributions which are paid across from the employer).

There is of course more to it than that for employers and their advisers to take into account:

• Legislative requirements
• Auto-enrolment compliance
• Environmental, Social and Governance issues
• Ensuring members understand how it all works
• Ensuring members are able to save in such a way to ensure that they are in a position to retire.

It would be fair to say that in many ways DC is the opposite of a DB pension scheme. In a DC scheme, the employer’s risks are far easier to quantify and manage – the employer simply needs to comply with auto-enrolment legislation and pay contributions across each month in line with The Pensions Regulators guidelines. This means that the members are now carrying the risk of the pension fund not providing the necessary level of retirement income, even if employers make generous contributions.

There are a number of ways that members (with help from employers and advisers) can help ensure that they are on track, and to do this, it helps to remember the key things that determine the level of retirement income that members will receive:

How much goes in

Total amount paid in – effectively, a DC pensions is a very tax efficient savings pot, so the more that is paid in, the larger the fund will grow. A periodic reminder to members of this fact is a good idea.

When contributions are made

Timing of contributions – the compound nature of growth can be a powerful thing! Contributions made earlier in life can change a member’s eventual fund size significantly – even if those early career contributions are relatively modest.

How the scheme is performing

Investment performance – this is an area where we would recommend specialist advice is sought – either through the governance provided around a pension scheme’s default fund, or through an individual adviser.

How benefits can be accessed

How members access their benefits – following the Government’s decision to provide more flexibility from 2015, this is an area where members need more help to ensure that they:

• Take enough income each year to cover their needs
• Don’t take too much income – as this could mean that their fund is exhausted.

Traditionally, DB schemes have been viewed as superior – the term ‘gold plated pension’ refers to DB pensions. However, the changes that took place in 2015 were significant, with many people feeling that they would prefer to have more control over how and when they access their money. This is perhaps acknowledging the fact that retirement income needs are not linear, and this flexible approach to retirement income needs can be better met with the freedoms and flexibilities afforded to DC pensions by the then Chancellor, George Osborne, in his 2014 announcement.

For further advice regarding any aspect of your corporate pension scheme, please don’t hesitate to contact your Brunsdon Financial Consultant.