Friday 14th June 2024

Word of the Week – Defined Contribution

Defined contribution pensions are an important aspect of retirement saving

Defined contribution pensions. Pictured: Older man looks at a phone with a younger woman.

Defined Contribution or ‘DC’ is a type of pension scheme commonly used in the UK.

In a defined contribution scheme, both the employer and the employee contribute a specified amount to the employee’s pension pot.

Here are the key points to understand about defined contribution schemes: 

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  1. Individual Pension Pots: Each employee has their own pension pot within the scheme. 
  1. Fixed Contributions: Contributions are fixed and usually a percentage of the employee’s salary. For example, an employer usually contributes a minimum of 3% of an employee’s salary to the pension, and the employee contributes 5%. 
  1. Investment Choices: Employees often have a range of investment options to choose from, such as shares, bonds, or funds. The employee can decide how to allocate their contributions among these options. 
  1. Market Risk: The value of the pension pot depends on the performance of the chosen investments. Therefore, the employee bears the investment risk. If the investments perform well, the pension pot grows. If they perform poorly, the pot’s value may decrease. 
  1. Retirement Benefits: The retirement benefits in a defined contribution scheme are not predetermined. Instead, they depend on the total contributions made and the investment returns on those contributions over time. 

Examples of defined contribution schemes in the UK include personal pensions, stakeholder pensions, and the National Employment Savings Trust (NEST).

These schemes are designed to build up a pension pot that can be used to provide an income in retirement, either through buying an annuity or using income drawdown.

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Photo credits: Pexels

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