What is a defined contribution plan?
Before getting into the details on Defined Contribution pension (DC) plans and their implications for US residents, it is worth understanding the basics first.
There are several types of DC plans. Essentially, there are two types of DC pensions; there are personal pensions arranged by yourself, like a SIPP, and there are workplace pensions arranged by your employer, like a Group Personal Pension.
Whilst structurally they are very similar, a workplace pension is typically much more limited than a personal pension. Although they can invest in multiple asset classes, they are typically limited to a small selection of restricted funds, approved by your employer and the pension administrator. However, despite being limited, employees in workplace DC schemes get more choice over their investments than those in workplace DB schemes, where the employer has sole control over investments as they provide a fixed rate of benefits, which they must provide to its members.
DC pensions carry a higher risk than defined benefit pensions which have a guaranteed level of pension income, as DC pensions have no such guarantee, and the member takes on all the investment risk. This can be challenging for those with no previous investment experience, who aren’t sure how and what they should be invested in.
Types of Defined Contribution Plans
If you are considering contributing to a DC pension scheme, you need to understand the different types of DC plans.
- A personal pension
Personal pensions are a type of defined contribution pension scheme that is set up without the involvement of an employer. They are individual contracts/trust agreements made between you and your pension provider. There are two common types of personal pensions.
- Stakeholder pensions
A Stakeholder pension must meet specified government requirements, such as limits on charges, flexible contributions, fee-free transfers, low minimum contribution limits, and a default investment fund into which your money will be invested if you feel it would be better not to choose. This is, undoubtedly, the most straightforward sort of personal pension, but can be rather limited, and lack many of the modern benefits that have arisen from the pension freedoms introduced in 2016, like Flexible Access Drawdown (although some stakeholder pensions do).
- Self-invested personal pensions (SIPPs)
This is the most flexible pension scheme available for people with UK pension assets. You have control over the exact investments that make up your SIPP. As a result, this sort of personal pension allows you to invest in a wider range of assets, while maintaining greater flexibility. They are also the most suitable arrangement for those who reside in the US.
Cameron James are specialists in these types of pension for US Residents, which you can read about in depth on our International SIPP page.
To learn more about SIPPs and International SIPPS, read our dedicated page here.
- Workplace pensions
A workplace pension is a type of defined contribution plan that your employer has set up and administers, with the help of a pension provider, on your behalf. Also known as a ‘Money Purchase scheme’, these schemes operate under a contributory basis – wherein typically, when you contribute, so will your employer. Today, all UK employers are required to enrol eligible employees in a workplace pension scheme automatically, and there are minimum levels of contributions that both employees and employers need to pay into the scheme each month.
The UK government has set minimum total contributions under automatic enrolment. From April 2019, if you earn over £10,000 a year and are over 22 years old, your automatic total contributions will be a minimum of 8%, your employee will contribute a minimum of 3%, and you will pay a minimum of 5% as the employee. If your salary is below £10,000 but above £6420, the employer will just have to contribute 3% of your earnings.
Otherwise, they are not required to contribute. If an employer fails to implement minimum contributions, it will not be viewed as a qualified pension plan by the HMRC. The employee can opt out of contributing, although this is typically not advisable. You can also increase your contributions above the minimum, which could also receive a related employer contribution. Some employers, particularly those in corporate environments such as Shell, Barclays and IBM, might contribute higher amounts such as 10-20% of your pensionable salary.
How does a defined contribution plan work?
How does defined-contribution tax relief work?
When talking about a UK defined contribution plan, there are two ways in which tax relief is dealt with concerning pension contributions:
- Net Pay Arrangement: Your employer deducts pension contributions from your gross salary, before it applies income tax. Therefore you automatically receive tax relief, as there is no tax paid on the contribution amount, which is then paid into your pension. This is the easiest way for an employee to receive tax relief, especially if a higher or additional rate taxpayer. This can be done as a form of Salary Sacrifice, which can also save you from paying National Insurance.
- Taxed at Source: Your whole salary faces income tax, and the pension provider will accordingly reclaim the tax relief from HMRC at the basic rate of 20%. This is the easiest form of tax relief for employers, as they don’t need to account for any deductions before applying income tax, and it is up to the Scheme to obtain the tax rebate from HMRC. Higher and additional rate taxpayers will have to claim back using Self Assessment tax return, as the amount provided by HMRC is limited to 20% via taxed at source, so the extra 20 or 25% tax relief needs to be obtained manually, which is admin intensive.
Clearly, a Net Pay Arrangement is a more convenient method for higher taxpayers, as you can obtain your maximum tax relief automatically and minimise your National Insurance charges. Usually, a net pay arrangement can only be used by an employer scheme, and not an individual personal pension. This is for both UK and US residents.
If you set up a personal defined contribution retirement plan, you need to arrange the contributions yourself. You have to remember that a defined contribution plan does not guarantee a specified or fixed level of retirement income. Thus, to plan your retirement more effectively, you need to estimate your expected pension income from your DC pension schemes. In addition, you can use the government website to use a defined contribution plan calculator.
Which? has stated that most single individuals will require an income of £19,000 p.a., with couples coming in at £28,000 p.a., to enjoy a comfortable retirement. This means a pension pot of at least £475,000 or £700,000 if you’re a couple. Do you have what is needed to retire comfortably, without luxuries?
When developing a strategy for your defined contribution pensions, there are mainly two stages you need to focus on – although an IFA will go into more detail, for better planning. The first stage is while you are working, and thus is also known as the “accumulation” phase, where you are saving and investing. In contrast, the second stage is when you retire, also known as the “disinvesting” phase, where you are withdrawing your money and using it for your lifestyle.
While you are working, your contributions are typically invested in stocks, shares, and other assets. The goal is to obtain a sizeable pot which allows you to maintain your lifestyle when retiring, thus the right investments must be picked to reach that goal.
However, you need to remember that the value of your pension pot can go up as well as down, as the amount of money in your defined contribution retirement portfolio will depend on the performance of your investments within the pension scheme.
In which ways can you take benefits from a DC pension?
You do not have to quit working to start receiving money from your pension fund, but you must be at least 55 years old (57 from 2028). Once at this point, you have several options on how to take the benefits.
- An Annuity: At the point when you retire, your pension provider will typically offer you the option to purchase a guaranteed income (an annuity) based on your pension pot size. However, it is not an obligation to take it until you need it, and you can leave the pot invested until you need to access the funds.
- Ad-hoc Lump-Sum: You can take a portion or the whole of your pension pot as a lump sum in one go. 25% of the lump sum will be tax-free, and the rest will be subject to your marginal rate of income tax.
- Flexible Access Drawdown: often referred to as pension drawdown. You can withdraw funds from your pension plan to live on in retirement. 25% of the amount you initially designate to drawdown will be payable as a tax-free lump sum, and the other 75% will be used to set up a taxable income stream.
The first 25% of your pension pot can be taken as a tax-free cash lump sum, with the remaining portion taxed by HMRC like any other income. This will be taxed at your maximum marginal rate. Thus, you need to be careful with how you withdraw your money from your pension and other assets, to minimise taxes. Our IFA’s at Cameron James can help you plan and develop a withdrawal strategy that minimises taxes for you and your family.
You must also consider how long you believe you will live and how much money you think you will need for the rest of your life. If you do not buy an annuity, the funds in defined contribution pensions may run out before you die, which could cause you to have a lower level of lifestyle than desired and/or anticipated. Under a typical 4% gross withdrawal rule, you can expect money to last around 30 years, and this is perhaps the most basic calculation you could make to estimate how much money you need to retire. I.e., whatever income you think you’ll need to retire, times 25. So, if you need £10,000 p.a., you would need c.£250,000 in your pension pot to retire. This is rather crude, and Cameron James advisers are much more nuanced in how they plan drawdown with clients, but it is a useful rule of thumb to help you gauge where you are.
As mentioned above, the size of the pension pot you’ll get when you retire can go up or down depending on how the investment performs.
- How much money do you contribute to your pension pot,
- How long you invested for,
- The option you choose when you retire,
- How much you take as cash,
- The performance of your investments,
- How your employer contributes to your pension pot (if you are in a workplace pension),
- Annuity rates at the time you access the pension (if you pick the annuity route),
- The charges that your pension provider has taken out of your pot.
As you approach retirement age, some schemes will move your money into lower-risk investments. If it does not happen automatically, you may be able to request it, but at Cameron James we typically will not advise this approach, as the need to “de-risk” your pension assets is based on faulty investment logic, especially if you do not intend to obtain an annuity, and would rather flexibly access your pot.
Your Cameron James financial adviser will be there to advise you throughout your life on what the most suitable option is for you, and they will take into account all of the above information, and more, when they come to their recommendation.
What if you change jobs?
Maybe you still have questions as to what to do with your DC pension when you change jobs. Just like many other pension schemes, if you change jobs, you can stop paying into your DC pension and leave it where it is.
In another case, if you do not want or cannot stay in your current DC pension, you can decide to transfer it, which is known as a pension “switch” by the UK regulator (The FCA) to your new employer or even to a personal or a stakeholder pension. But bear in mind that there might be some risks and additional costs associated with the decision you make.
Cameron James advisers have a vast level of experience providing advice on workplace pension schemes, and whilst in many occasions a switch is advised, there are also several occasions where a simple change in the underlying workplace pension portfolio is advised, with no reasonable rationale to move the pension pot.
(Read our article on what to do with your US pension after changing jobs) here
What happens to the savings in my DC pension?
As stated before, your contribution and your employer’s contribution in a DC pension scheme will be invested in the capital markets with the objective of growing your funds over the years before and after you retire.
In a DC scheme, you have the flexibility to choose “riskier” investments to try to maximise your fund growth, which has the ability to provide a greater pension income at retirement, assuming those investments perform well.
Who manages my money in a DC plan?
When talking about who manages and administers your money, you need to know there are two primary types of DC pension schemes.
- Trust-based schemes are run by a board of trustees who supervise the investments and management of your pension. They will choose some professionals to take charge of your money. They also have an obligation to you as the scheme member to get the best deal.
- Contract-based schemes are a type of DC pension scheme where your employer has appointed a pension provider to manage your pension scheme. For example, it can be an insurance company. In this case, the contract or agreement is not between you and your employer, but it is between you and the pension provider your employer has selected.
Typically a contract-based scheme offers a greater choice in investments for your pension pot compared to a trust-based scheme, as they are usually newer and more flexible arrangements.
Advantages and Disadvantages of Defined Contribution Plan
The advantages of a DC pension plan
One of the advantages of a defined contribution plan is that it allows you to accumulate substantial investments for retirement while providing significant tax benefits that you cannot obtain in any other way. Thus, when considering the balance of risk, reward, and how easy it is to access your money, pensions are the best form of investment for retirement for the vast majority of people, especially US persons living in the UK.
Another advantage of defined contribution plans is their flexibility. You can access the money in various ways, varying your income and deciding how much to guarantee, making this type of pension more suitable if you want to phase your retirement or continue occasionally earning after you retire. You can even continue to save for your pension and receive tax breaks until the age of 75.
Furthermore, any unspent pension pot can be passed on tax-free to your beneficiaries after your death before 75. After age 75 the pension can be passed on free of Inheritance Tax, but will be subject to your beneficiaries marginal rate of income tax when they withdraw from it. As a result, your pension can be an excellent vehicle for reducing or eliminating inheritance tax. This way, your family will have more to inherit, and your legacy will be more significant.
Defined contribution pensions are also not dependent on the solvency of your employer. With a Defined Benefit Scheme, there is a slight but not insignificant risk that the pension scheme might collapse if the employer becomes insolvent and cannot pay out the full amount. However, because DCs are independent of the employer, there is no such risk.
The disadvantages of a DC pension plan
The main disadvantage of defined contribution plans is that they are a finite pot of funds that can run out during your lifetime, unless used to purchase an annuity. Your investments are also affected by capital market performance, which means that a significant market downturn can reduce your retirement savings, and this risk is particularly problematic if the downturn happens at the same time as when you retire and wish to start accessing your pot, which is a risk known as “sequencing” risk.
Another perceived disadvantage is that the money cannot be accessed until you are 55 or older. As such, if you needed to access funds before the age of 55, then there would be significant penalties to pay. This is why ISA’s and/or brokerage accounts can also be very beneficial places to invest excess income, as they have no such age limits, but lack the substantial tax relief that pensions receive.
Defined Benefit Plans VS Defined Contribution Plans
You might have heard a lot about both defined benefit and defined contribution schemes, but you may not entirely understand what they mean. What is the main difference between a defined benefit plan and a defined contribution plan?
The main difference between defined benefit and defined contribution plans is that defined benefit pensions guarantee a fixed, escalating income. It is usually determined by how long you worked for your employer and how much you earned. In contrast, defined contribution benefits are determined by factors such as the fund’s investment performance, the amount contributed to the pension, and the time invested.
To make a better comparison, have a look at the table below.
|Defined benefit plans||Defined contribution plans|
|Retirement income is guaranteed for life||Retirement income is not guaranteed for life|
|The Scheme is responsible for investing contributions to meet defined pension benefits||The member is responsible for investing the contributions (although there is automatic enrolment)|
|Known retirement income||Unknown retirement income|
|Inflation protection built-in||Inflation protection is not built-in|
|Investment results do not affect employee’s pension benefits||Investment results increase or decrease pension benefits|
|Investment decisions are managed professionally.||Investment decisions are made by the member|
|Risk assumed by the Scheme||Risk assumed by the member|
|The benefit is often calculated as a percentage of the final salary of the employees and the number of years they have worked for the company||The contributions to employer pension scheme are pre-determined, generally, as a percentage of the salary of the member|
Cash equivalent transfer value (CETV)
A CETV is only applicable to defined benefit pension schemes and not defined contribution pension schemes. So, if you are a member of a DB pension scheme, you are entitled to a CETV. A DC value is known as a transfer value, and is based on the value of the underlying funds at that point in time.
CETV refers to the value, at that point in time, of your guaranteed pension benefits. This is the amount you can transfer to another plan in exchange for giving up your rights under the scheme. If you want to transfer from your scheme, you must apply for your CETV statement.
The CETV is calculated by calculating the sum required to provide an equivalent pension to the scheme pension when you reach retirement age. This lump sum is then discounted based on how far you are from retirement to determine the value of those benefits at today’s date, taking into account the time value of money. To calculate the cash equivalent transfer value, the scheme makes several assumptions.
The DB scheme must provide the CETV within three months of receiving a request. You have no legal right to a CETV during the 12 months preceding retirement. You can only have one-free CETV within a 12-month period, but some schemes provide more, and most will allow for a 2nd CETV within a 12-month period, for a small fee. Find out more about CETV by reading our analysis here.
Do you have a DB or a DC?
Some clients are not quite sure whether they have got a DB or a DC. However, when talking about the documents or paperwork needed in UK pension schemes, you should know it is a defined contribution if:
- It does not mention anything about guarantees
- It has details of investment funds and values
- There is no mention of any needed for formal advice
Additionally, you should know it is a defined benefit if:
- There is reference to the need for formal FCA Advice
- It mentions guarantees
- There is no mention of investments or fund performance
- It mentions inflation linked
So, if your UK pension transfer meets the characteristics of a defined benefit scheme, go to our DB page to learn more.
Is a 401k a defined contribution plan?
As mentioned above, a 401(k) plan is the most well-known defined contribution plan in the USA. Employees can decide to defer receiving a portion of their salary, which is instead contributed to the 401(k) plan on their behalf, before taxes. Employers also usually contribute a %, with many schemes having large contribution rates, as part of their employment incentives package.
Employees participating in 401(k) plans assume responsibility for their retirement income by contributing a portion of their salary and, in numerous instances, making their own investment decisions.
UK defined contribution plan vs 401k plan
Defined contribution plans have become the most popular type of occupational pension in the United Kingdom. As a result, the country’s businesses, employees, and policymakers are concerned about their participation, investments, and withdrawals.
While in the US, 401(k) plans, named after the tax code section that provides the plan’s tax-deferred characteristics, are the most common type of employer-sponsored defined contribution plans.
Employee contributions and employer matching and profit-sharing contributions are the foundation of a 401(k) plan. It is typically tax-deductible at the time of contribution and invested in funds over which you have investment control.
In some cases, people look at consolidating a 401k into an IRA to make it more flexible and give the holder more control over their pension. Similar to UK pensions where you can consolidate your pensions into a SIPP or QROPS for flexibility and wider choice of investments.
Amounts held in these plans are tax-deferred. The contributions of employer and employee support the plans, and employees, like in the UK, have a variety of investment options from which pension holders can choose. Additionally, A 401(k) plan has an annual limit.
What is annual defined contribution limit 401k?
Contribution limits for 2023 allow employees who participate in defined contribution plans to contribute up to $22,500. They can make catch-up contributions in addition to their annual contributions if they are 50 or older. For 2023, catch-up contributions to defined contribution plans are limited to $7,500.
Annual additional contributions are the total of all employer contributions, employee contributions, employee elective deferrals (but no catch-up contributions), discretionary contributions, employer matching, and any forfeiture allocations made to a participant’s plan account.
The maximum annual additions limit under defined contribution plans in 2023 is $66,000 per participant. However, it can be increased to $73,500 if you make catch-up contributions (Age 50 or older).
A 401(k) rollover
A 401(k) rollover is a transfer of funds from an old 401(k) to an IRA or another 401(k) (k). Normally, the funds must be transferred to the new account within 60 days after transferring from the old 401(k).
You have several options for rolling over your employer-sponsored 401(k) retirement plan if you have a 401(k) from a previous job. Making the correct decision about where to roll over your account can save you tens of thousands of dollars. And, of course, making the wrong decision can cost you just as much.
Can you transfer your 401(k) to a UK defined contribution pension and vice versa?
Many American expatriates want to know if they can transfer their 401(k) to a UK pension scheme. Unfortunately, the answer is no. Transferring into a UK scheme is not possible. If you wish to transfer your pension scheme to another pension scheme in the UK, the pension scheme must be HMRC-approved. Unfortunately, a 401(k) transfer to a UK pension is not available at this time, as HMRC does not currently recognise any US pensions as QROPS.
Likewise, under US law, you are not permitted to convert your UK pension to a 401k. However, there is the option for you to transfer UK pension and have accessibility in the US , such as an international SIPP. You can speak with a Cameron James adviser if you want to learn more. This is something that should always be discussed with a regulated financial adviser. We have a dedicated page discussing International SIPPS, check it out here.