In a defined contribution pension scheme, also known as a 'money purchase' scheme, the final pension amount will depend on:
- the amount of money paid in
- the investment performance of the pension fund
- the age at which the fund is used to purchase an annuity - the later this is, the higher the annuity payments are likely to be
- the level of annuity rates at the time
- the ancillary benefits offered - such as spouses' pensions, or annual increases in pensions paid
Some employers provide occupational defined contribution pension schemes for their employees. Both employers and employees can make payments into such a pension scheme. Once the employee leaves, these payments cease.
The investment risk is moved from the employer to the employee with an occupational defined contribution scheme and the risk that the employer will have to find substantial extra sums of money to fund the scheme because of poor investment performance is eliminated.
Occupational defined contribution schemes generally operate through a trust. Objectives are set out in the trust deed and day-to-day decisions are made by the trustees. Employers still have some key responsibilities, either as employers or as trustees - for example, on the level of employer contribution, or the extent of provision for dependants.
Defined contribution schemes must offer members the open market option whereby members can transfer funds at retirement to draw an immediate annuity with another provider. Members of a defined contribution scheme approaching retirement will need timely information on this option and other retirement income options.
Employees can also make regular payments for their retirement through individual personal pension schemes. These are defined contribution schemes and the risk of poor investment performance is carried by the employee. In some cases, employers will make payments into these schemes for the benefit of their employees.
Some employers may also arrange for a pension provider to set up a group personal pension (GPP) arrangement. In a GPP, employees contribute to individual personal pensions which are then grouped together and managed by the pension provider, to reduce costs. The employer may often pay the administration costs of running a GPP.
Tax relief on pensions
Employees can contribute up to 100 per cent of their earnings and get tax relief (or even if an employee's earnings are less than £4,000 a year they can get tax relief on contributions up to that amount as long as the scheme uses the relief at source method for giving tax relief). However, there is a limit on the amount of tax relief that may be given on pension scheme contributions and other increases in pension rights each year. The annual allowance for tax year 2020-21 is £40,000.
Employer contributions also generally qualify for tax relief as they can be set off as expenses, although employers should seek professional advice to make sure their contributions qualify as true business expenses. See how to choose the right pension scheme.
Most personal pension decisions are made by individual pension holders and the pension managers (the 'pension providers'), or investment specialists. However, employers are still legally obliged to ensure that employee contributions deducted from wages reach the fund within 19 days of the end of the month in which they were deducted.
The responsibility for registering the pension scheme rests with the pension provider. You must also keep employees informed about pensions.
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