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What is a defined contribution pension?

All you want is a comfortable income throughout retirement, so why can it feel like the pensions industry is built in a way to champion complexity?

Saving for your future doesn’t need to be difficult, especially when there are generous tax benefits to building up your pension pot.

What is the state pension?

You’re eligible to get income from the government to see you through retirement once you hit state pension age, as long as you’ve contributed to national insurance for 30 years.

You’ll get £164.35 a week from the state pension, unless you reached the pension age before 6 April 2016, which means you’ll get the old state pension of £125.95 a week. The new state pension increases each year by either UK wage growth, inflation, or 2.5%, whichever is higher. This is known as the state pension triple lock. 

Unfortunately, at under £8,500 and £6,500 respectively, you might not be able to rely on the state pension to cover what you need for a comfortable retirement.

Instead, you should look to supplement your state pension with income from a defined contribution scheme.

What is defined contribution?

A defined contribution pension is where you and your employer pay into your pension pot throughout your working life. Your pension pot is essentially a fund that invests in the financial markets.

By investing your pension fund, you aim to protect your money from the impact of inflation and grow it for your retirement.

There are different features of a defined contribution pension, especially after pension freedoms. You need to make sure you find the right one for you, especially as you’re saving for your future.

Some target date funds automatically adjust the composition of your portfolio to ensure its suitable for your time horizons, some allow you to opt for income  drawdown once  your hit retirement age.

The amount of income you get from your defined contribution pension will depend on how much you pay in, how your investment fund performs, and the choices you make during retirement.

Tax benefits to pensions

There most important benefit to saving into a pension is the generous tax relief. You’re able to claim relief relative to how much tax you pay, so you’ll pay £8,000 for a £10,000 pension contribution if you’re a basic rate payer, and just £6,000 if you’re in the higher rate band.

These tax benefits really add up over the long-term. A higher rate taxpayer and their employer will only need to pay in £300,000 over their working career for a £500,000 pension pot.

Retire in style

Once you reach 55, you can access your defined contribution pension and chose to either take 25% as a tax-free lump sum or make smaller withdrawals as you go along – this is known as income drawdown. You can still take a quarter of this tax-free; the remainder will be charged at your usual rate of income tax.

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By making an investment, your capital is at risk.

Be careful, a larger lump-sum withdrawal might tip you into the higher tax bracket next year, which means you could be paying more out in tax than you expect.

Once you’ve spent decades building up your pension pot, the last thing you want to do is run out of money during retirement. That’s why it’s important you secure your retirement income.

Savers used to have to buy an annuity with their pension savings, but recent pension freedoms have opened up the options, with income drawdown being an option – or a mixture of the two.

Like everything in the financial world, there are pros and cons to both.

Annuity versus income drawdown

An annuity is where you transfer your pension pot to a provider, who guarantees you an income throughout retirement. The amount you get as income will be expressed as a percentage of how much you transfer, but can be notoriously small – especially in a low interest rate environment.

If you transfer £200,000 of savings and are offered an annuity rate of 5%, for example, you’ll get £10,000 a year. Annuities are great for those who need the security of a reliable income, but it’s not ideal for those who need a bit more flexibility.

There’s no dipping into your annuity pot if the washing machine breaks, you want to go on an impromptu holiday, or you want to help your child out with a deposit.

Those wanting a bit more flexibility can opt for income drawdown instead. By keeping their money invested in the market, savers hope to benefit from market momentum – investments can fall in value as well as rise.

You can draw money out from your pension pot throughout retirement, but you must keep on top on your spending! Once it’s gone it’s gone!

When should you start saving?

When it comes to any form of saving, the earlier you start the better. Not only do you have longer to build up your cash pile, but you can also benefit from compounding – where your returns generate their own.

To have a comfortable income of £26,000 a year in retirement, a couple in their 20s will have to save £131 a month and a couple in their 30s will have to put away £198. Leave it any later and this bumps up to £338 for a couple in their 40s and £633 for those even closer to retirement  in their 50s.

We live in a world of competing priorities, and it’s easy to feel overwhelmed when constantly being accused of not saving enough. Don’t. You can’t change the past, but you can take control of your future today.

You can use Moneyfarm’s Pension Calculator to help you work out how much you need to be saving a month to get the income you want in retirement, or start one of Moneyfarm’s regular investment plans.

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