Defined Contribution Pension Transfers - Key points (Est Reading Time - 22 mins 37 secs)

What Is a Defined Contribution Plan?

Before getting into the tricky details of the Defined Contribution pension plan (DC) for US residents, first, we must understand the basics. There are several types of DC plans. There are personal pensions arranged by you directly, and there are workplace pensions arranged by your employer.

You are also given a choice of investment plans that the contributions will go into, this is more limited than personal pensions. However, employees in workplace DC schemes get more choice over their investments than those in workplace Defined Benefit (DB) schemes, where the employer has sole control over the investments.

DC pensions carry a higher risk than Defined Benefit pension plans that come with a guaranteed level of pension income. The DC pensions have no such guarantee. This can be challenging for those with no previous investment experience.

Types of Defined Contribution Plans

If you are considering contributing your fund to a DC pension scheme, you need to understand these types of DC plans.

1. Personal Pensions

Personal Pensions are a type of Defined Contribution pension scheme that you. They are individual contracts 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.
  • Self-invested personal pensions (SIPPs)
    You have control over the exact investments that make up your pension fund with SIPPs. As a result, this sort of personal pension allows you to invest in a wider range of assets while maintaining greater flexibility.

To learn more about SIPPs read our dedicated page here.

2. Workplace Pensions

A workplace pension is a type of Defined Contribution plan that your employer sets up, also known as a ‘Money Purchase Scheme’. When you contribute to the plan, your employer will also contribute to the scheme. Today, all employers are required to enrol eligible employees in a workplace pension scheme automatically.

The UK government has set minimum total contributions under automatic enrolment. From April 2019, if an individual earns over £10,000 a year their automatic total contributions will be a minimum of 8%. The employee will contribute a minimum of 3% the employer will pay 5%. For salaries 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 HMRC. The employee can opt out of contributing and can also increase contributions above the minimum, which should carry a related employer contribution.

Workplace DCs

A defined-contribution plan is the most common type of workplace pension scheme. It is also known as a ‘Money Purchase’ pension scheme. You will pay money into your DC Pension Scheme, and your employer will typically contribute a fixed or percentage amount of your contributions.

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:

  1. Net Pay Arrangement: Your salary faces income tax on the gross amount left after pension contributions are deducted from your salary.

  2. Taxed at Source: Your whole salary faces income tax, and the pension provider will accordingly reclaim the tax relief from HMRC of 20%, higher-income taxpayers will have to claim back using a Self-Assessment tax return.

Clearly, a Net Pay Arrangement is a more convenient method for higher taxpayers, as you can fall into a lower tax bracket for income tax. Usually, the first arrangement can only be used by an employer, not an individual. 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 need 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 can estimate your expected pension income from your DC pension schemes. In addition, you can go to the government website to use a Defined Contribution plan calculator.

When talking about Defined Contribution Pensions, there are two stages you should understand. The first stage relates to while you are working, and the second stage is for when you retire.

While you are working, your contributions are typically invested in stocks, shares, and other investments. The goal is to grow the fund over the years in advance of your retirement. In this case, you can choose a range of funds to invest in.

However, you need to remember that the value of your pension pot can go up and down as the amount of money in your Defined Contribution retirement portfolio will depend on the performance of your investment.

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How Can You Take Benefits from a DC Pension?

The second stage of this pension scheme is related to when you retire. You do not have to quit working to start receiving money from your pension fund, but you must be at least 55 years old. At this point, you have several options on how to use the benefits.

  1. An Annuity: At the point you retire, your pension provider will typically offer you a retirement pay (an annuity) based on your pension pot size. However, it is not an obligation to take it.

  2. Lump-Sum: You can take the whole of your pension pot as a lump sum in one go. It is also safe to take only some of it as a lump sum. The first 25% of your fund will be tax-free, and the rest will be subject to income tax, and of course, will be taxed in the usual way.

  3. Flexi Drawdown: Often referred to as a pension drawdown. You can withdraw funds from your pension plan to live on throughout your retirement (usually up to 25% of the amount as a tax-free lump sum).

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 not to push yourself into a higher tax bracket by taking cash from your pension.

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 your Defined Contribution pensions may run out.

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 and also depending on:

  • How much money do you contribute to your pension pot
  • How long you save 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 resign (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 that to happen. Just talk to your financial adviser. If you are uncertain about what to choose and what to do, you can always get advice from a regulated financial adviser. One of the best financial advisers you can get advice from is Cameron James.

What if You Change Jobs?

Maybe you are still questioning 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 select to leave it where it is.

In another case, if you do not want to or cannot stay in your current DC pension, you can choose to transfer it to your new employer or even to a personal or stakeholder pension. But bear in mind that there might be some risks and additional costs associated with the decision you make.

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 to a DC pension scheme will be invested in the stock market with the objective of growing your funds over the years before you retire.

In a DC scheme, you have the flexibility to decide riskier investments to maximise the growth of your fund and provide greater pension income for your retirement, assuming investments perform well.

If you look at the Defined Benefit plan vs Defined Contribution plan accounting, you will realise that accounting for Defined Contribution pension plans is easy. Each year, paid contributions are counted as an expense, unpaid contributions are debt, and overpaid contributions are an asset.

Who Manages My Money in a DC Plan?

When it comes to the question ‘who manages my 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 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, it is between you and the pension provider your employer has selected.

It is safe to say that a contract-based scheme offers a greater choice in investments for your pension pot compared to a trust-based scheme.

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The Advantages and Disadvantages of Defined Contribution Plan

The Advantages

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 accessible form of investment for retirement.

Another advantage of Defined Contribution plans is their flexibility. You can access the money in various ways, vary your income, and decide 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 the age of 75. As a result, your pension can be an excellent vehicle for reducing or eliminating the inheritance tax. This way, your family will have more to inherit.

Defined Contribution Pensions are also not dependent on the solvency of your employer. There is a slight but insignificant risk that the pension scheme might collapse if the employer becomes insolvent and cannot pay out the full amount. Because the fund is independent of the employer, there is no such risk with a Defined Contribution Plan.

The Disadvantages

The main disadvantage of Defined Contribution Plans is that they are a finite pot of funds that can run out unless used to purchase an annuity. Your investments are also affected by stock market performance, which means that a significant market downturn can reduce your retirement savings.

Another perceived disadvantage is that the money cannot be accessed until you are 55 years of age or older. However, this is only logical if you want it to last the rest of your life. Furthermore, keep in mind that the money you withdraw from a pension is taxable because it counts as income (except for the first 25%).

Freezing a Defined Contribution Plan

When a pension is frozen, it remains intact, but new contributions are not permitted. A freeze is typically only applied to Defined Benefit plans and can be either hard or soft. A hard freeze means that you will not lose any existing benefits, but you will also not receive any new benefits from the plan.

A soft freeze typically only impacts certain employees, such as new hires or those not yet eligible for the pension plan. If you are in this situation, you will not be able to receive any plan benefits.

Because future benefit accruals are halted, freezing a Defined Benefit plan usually results in some immediate cost savings. The freeze, however, does not address unfunded liabilities or eliminate cost volatility.

If employer contributions are not received for a period of time, participants who remain in the plan become fully vested, but this does not affect the plan's qualification. A DC plan, on the other hand, is rarely completely frozen.

Defined Benefit Plans Vs Defined Contribution Plans

You might have heard a lot about both Defined Benefit and Defined Contribution schemes, but you do 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 is that Defined Benefit guarantees a fixed income. It is usually determined by how long you worked for your employer and how much you earned. In contrast, Defined Contribution is determined by factors such as the fund's investment performance and the amount you contribute to the pension. To make a better comparison, take 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 employer is responsible for investing contributions to meet defined pension benefits. The employee is responsible for investing the contributions (although automatic enrollment).
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 an employee’s pension benefits
Investment decisions are managed professionally Investment decisions are made by the employees
Risk assumed by the employer. Risk assumed by the retiree and the employee
The benefit is often calculated as a percentage of the employee’s final salary and the number of years they have worked for the company. The contributions to the pension plan (both by the employee and the employer) are pre-determined, generally, as a percentage of the employee’s salary.
Cameron James - Official Financial Times Commentator

We worked hard to achieve our relationship with the FT - we help them breadown lastet UK Pension updates.

Cash Equivalent Transfer Value (CETV)

CETV refers to the cash value placed on UK 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 determined by calculating the lump 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 calculate the cash equivalent transfer value, the scheme makes several assumptions.

CETV, on the other hand, 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.

The scheme must provide this within three months of receiving the request. You have no legal right to a CETV during the 12 months preceding your retirement. You can only have one free CETV within a 12-month period. 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 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 consists of 5-10 pages.
  • It is simple as it only asks for your name and address. Not only that, but it does not mention a guaranteed date or FCA required IFA, as it is likely a smaller pot value of up to £250K.

Additionally, you should know it is a Defined Benefit if:

  • The document is 40-50 pages long.
  • It consists of complex information as it mentions the guaranteed date of CETV, and it needs FCA Regulated IFA.

So, if your UK pension transfer meets the characteristics of a Defined Benefit scheme, go to our DB page to learn more. To provide you with a broader insight on qualified Defined Contribution plans, later, we will be providing you with a Defined Contribution plan example.

Types of Pension Plans in the US

Similar to the UK, there are also types of pension plans in the US that have been “US-reviewed”as Defined Benefit pensions and Defined Contribution pensions. A Defined Benefit plan guarantees a fixed monthly benefit upon retirement. Each scheme will have a plan formula that takes several factors into account for each individual: salary and service.

On the other hand, a Defined Contribution plan does not guarantee a specific amount of retirement benefits. Instead, in these plans, either the employee or the employer (or both) can contribute to the employee's account under the plan, often at a fixed rate, such as 5% of annual earnings.

Just like in the UK, the account’s value will fluctuate due to changes in the value of the investments. One example of Defined Contribution plans is a 401(k).

The 401(k) plan is the most common DC retirement plan. Employees and employers can make tax-deferred contributions to the plan through their salaries under this plan. Most 401(k) plans offer retiring employees a variety of ways to receive a plan account cash balance.

Aside from the well-known 401(k) plan, the following type of schemes could be established to provide occupational pension coverage in the US:

  • A 403(b) plan is a retirement plan sponsored by an employer. Employees of universities, public schools, and non-profit organisations can make tax-deferred contributions to the plan through their salaries under this plan.
  • A 457 plan is an employer-sponsored retirement plan that allows state and local government employees to make tax-deferred contributions from their pay cheques to the plan.
  • SIMPLE IRA is an IRA-based plan that provides employers with fewer than 100 employees with a simplified way to contribute to their employees' pensions. So, when you hear people ask, “Is a Simple IRA a Defined Contribution plan?” The answer is yes.
  • SEP IRAs: Simplified Employee Pension plans that do not have the same start-up and operating costs as traditional work-based retirement plans and are primarily designed for small businesses. SEP-IRA trustees are typically mutual funds, banks, insurance companies, or other approved financial institutions.

When talking about health plans, it is interesting to know there are some schemes in the United States offering a Defined Contribution health plan. It is a consumer-driven healthcare program where employers choose a fixed dollar amount to contribute to an employee's healthcare.

Under a Defined Contribution health plan, you are responsible for exploring and purchasing your own insurance policies.

Is a 401k a Defined Contribution Plan?

As mentioned above, a 401(k) plan is the most well-known Defined Contribution plan. 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.

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.

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UK Defined Contribution Plan Vs 401k Benefit 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 participation, investments, and distributions.

While in the US, 401(k) plans, named after the section of the tax code 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 which you have investment control over.

In some cases, people are consolidating a 401k into an IRA to make it more flexible and give the holder more control over their pension. Similar to a UK pension, where you can consolidate your pensions into a SIPP or QROPS for flexibility and a wider choice of investments.

Amounts held in these plans are tax-favoured. The contributions of the 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 2021 allow employees who participate in Defined Contribution plans to contribute up to $19,500. They can make catch-up contributions in addition to their annual contributions if they are 50 or older. For 2021, catch-up contributions to Defined Contribution plans are limited to $6,500.

Annual additions 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 plan in 2021 is $58,000 per participant. However, it can be increased to $64,500 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 from the old 401(k) within 60 days…

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 rollover your account can save you tens of thousands of dollars. And, of course, making the wrong decision will 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 recognize the transfer.

Likewise, under US law, you are not permitted to convert your UK pension to a 401k. You do not need to be concerned about this, as there is an option for you to transfer UK pension and have accessibility in the US , such as an international SIPP. You can speak with an expert 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 SIPP, check it out here.

Defined Contribution Benefit Plan Vs SIPP and QROPS

SIPPs

A Self-Invested Personal Pension (SIPP) is a type of pension plan in which you control how your savings are invested. An International SIPP is a type of defined-contribution personal pension, which means the value of your pension pot when you retire is determined by the amount you contribute and the performance of your investments.

SIPPs, like DC plans, are adaptable and portable. You can continue to contribute even if you change jobs or stop working.

QROPS

QROPS is an international pension scheme based in the UK and licensed with Her Majesty's Revenue and Customs (HMRC). Transfers to QROPS will only be taxed at a 25% rate if the individual and the QROPS are in multiple countries.

SIPPs and QROPS are aimed at expats with existing UK pension rights, but a QROPS is better if you have a large pension pot (close to the Lifetime Allowance, which is currently £1,073,00 for 2020/2021) because it helps you reduce future tax from exceeding the allowance.

HMRC has established stringent rules over transferring your UK pension overseas. Unfortunately, no British pensions are recognized by US law. This is a problem for US residents who wish to transfer their UK pension retirement funds into a QROPS.

Trust Your Defined Contribution Pension Transfer to Cameron James

You don't have to be concerned about it! If you are a non-UK resident, an International SIPP for expats allows you to hold assets appropriate for international clients as well as in other currencies while still meeting key UK regulatory requirements.

An International SIPP is an extension of the UK SIPP, originally designed for non-UK residents who prefer to keep their pension assets in the UK rather than transfer them to an overseas pension solution. Foreign nationals residing in the UK also use it to provide a diverse range of investment opportunities and flexible retirement benefit options.

Finally, the Cameron James team hopes you found this article useful. Using the social buttons below, you can share this article with any expat colleagues or friends you think would benefit from this information.

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I have been in the UK Pension Transfer industry for over 11 years, and have witnessed seismic changes in the UK Pension rules over the course of that decade. Most to the benefit of the UK Chancellor or to Chequer!

My 5 years as CEO of Cameron James, have certainly been the most rewarding. My goal, has been a simple one. Provide clients with transparent financial advice on a low-cost basis, for them to make informed decisions to protect their families best interests.


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