Defined contribution: Money purchase schemes
Money purchase schemes provide benefits on retirement based on the amount of money that has been paid in to the scheme, how long this money has been invested, the level of charges and investment returns over this period.
How money purchase schemes work
Following the closure of many defined benefit pension schemes over recent years, money purchase schemes have become the most common type of pension scheme available.
Money purchase schemes cover a wide range of different pension plans, some are provided by employers (employer-sponsored schemes) and others are personal (or individual) schemes.
An employer may decide to set up an employer-sponsored (workplace) money purchase scheme to provide retirement benefits for their employees. There are a number of different types of employer-sponsored money purchase pension schemes. These include:
- Contracted-out money purchase schemes (COMPS);
- Contracted-in money purchase schemes (CIMPS); and
- Small self-administered schemes (SSAS).
An employer will contribute to an employer-sponsored plan and may require that employees joining the scheme also contribute.
Alternatively, an employer may offer employees personal schemes (even though these may look like an employer-sponsored scheme). Examples include:
- Group personal pensions (GPPs);
- Group Stakeholder pensions (GSHPs);
- Self-invested pension plans (SIPPs); and
- Group self-invested pension plans (GSIPPs)
If your employer offers you a personal scheme, they may also decide to contribute to your scheme.
Whether a money purchase scheme is an employer-sponsored or a personal scheme, it will work in a similar way. Below, we will look at how employer-sponsored money purchase schemes work, but you can find details on how personal schemes work here.
How employer-sponsored money purchase schemes work
An employer-sponsored scheme may be set up as a trust-based scheme or may be provided by a pension provider, such as an insurance company or investment platform.
Your employer decides the levels of contributions to the money purchase scheme. The contributions are usually a percentage of your earnings, although it could be a monetary amount. Your employer will set rules to define what is meant by ‘earnings’. For example, some schemes don’t count overtime, commission, bonuses or the value of benefits in kind (other benefits that are not paid as cash to you).
Your employer may also only count a proportion of your weekly or monthly pay or salary. The amount of your earnings that are used for calculating the amount of contributions paid is often called ‘pensionable earnings’.
Your employer will contribute to an employer-sponsored workplace money purchase scheme and may also require that you contribute at least a minimum level. If you decide to contribute more, your employer may decide to ‘match’ the additional contributions and make higher contributions for your benefit. You will receive tax relief on any contributions that you pay, subject to certain conditions.
Contributions made to a money purchase scheme by you and/or your employer are invested in your individual ‘pot’ held in your name.
How are contributions invested?
Many money purchase schemes offer you a choice of how your contributions and the contributions your employer makes on your behalf are invested. The choice may consist of a limited range of funds or could allow investment in a wide range of different types of funds. Your employer may pay for you to receive some financial advice to help you select the funds that may be appropriate and suit your attitude to risk.
You can decide to move money from one fund to other (switch funds) or to redirect future contributions to a different fund.
Over time, the value of your pot will change and its value at a point in time will depend on:
- how much has been paid into it;
- the length of time that each contribution has been invested;
- investment growth over this period;and
- the charges deducted from the scheme.
Some employers may decide to cover the cost of the scheme’s charges, meaning that your pot grows faster.
You should be sent regular statements showing the value of your pot, but it's always possible to ask the scheme administrator for a value at any time. Some schemes have an online system that you can access that will provide details of your pot and a valuation.
When you reach retirement and decide to draw benefits from the scheme, the value of these benefits will depend on the value of your pot. The earliest that you can usually draw benefits from the scheme is your 55th birthday.
Generally, you can decide whether to receive an income only from the scheme or a tax-free cash lump sum and a (reduced) income. The amount of tax-free cash sum that you can elect to take is usually up to a maximum of 25% of the value of the pot at retirement. The remaining balance of the value of the pot is then used to provide income. There are several options in the way that income can be taken, including:
The amount of income received by you depends on the options that are selected. These include:
- the income continuing to be paid to your dependant on your death;
- the income increasing each year to offset the effects of inflation; and
- the frequency at which the income is paid.
Changes as of April 2015
As of the 6th of April 2015, there are no restrictions on how much income you can withdraw from your defined contribution pension pot, but any income that is withdrawn above the 25% tax free lump sum limit (and it's possible to withdraw your whole remaining pension pot in one go) may be subject to income tax.
Please note that pensions that are paid are liable to income tax, but are not liable to National Insurance contributions.
If you were a member of an employer’s money purchase scheme but have since left, you may have kept benefits under the scheme. When you left, the scheme administrator should have provided you with a pension statement showing the amount of pension benefits that you have built up.
If you've joined a new pension scheme, you may want to consider transferring the value of any old pensions to the new scheme. Please talk to us if you are interested in this, as there are lots of things you might want to consider before deciding to transfer.
How can I find out what benefits my money purchase scheme offers?
You would normally have been given a booklet when you joined the scheme. This booklet would give you details of the benefits. If you no longer have the booklet, contact the Scheme Administrator and ask for details.
I have lost the contact details for the Scheme Administrator, what can I do?
If you have lost track of your pension details don't worry. There are lots of things you can do to locate your 'lost pension'. Click here for more information.
Where can I find out more?
If you need more information, please contact us. A pension specialist from our team will be happy to help with whatever pensions-related question you have. Our help is always free.