Defined contribution pensions explained

A defined contribution pension is a pot of money built up from what you and, if it is a workplace pension, your employer pay in. The provider invests that pot, for example in shares, and what you end up with depends on how much went in, how well the investments perform, the charges deducted along the way, and how you choose to take the money¹. Unlike a defined benefit pension, it does not provide a guaranteed income: it provides a pot of money you can use in retirement².

Defined contribution pensions are now the most common type of workplace pension³, and most people saving into a pension today are building one. The trade-off is simple and important: you carry the investment risk, so the value of your pot can go up as well as down, but you also get flexibility over when you retire and how you use the money, which a final salary scheme does not offer⁴.

What a defined contribution pension is and how it works

In a defined contribution pension scheme, your pension pot is put into various types of investment, such as shares¹. The money paid in by you or your employer is used to buy investments by the pension provider, and the amount you have at retirement depends on how much was paid in and how those investments perform⁸. Four things determine the size of the pot you end up with: the contributions going in, the tax relief added by the government, the investment growth over the years, and the charges taken out⁸.

This is the key difference from a defined benefit scheme. A defined benefit pension is a workplace pension based on your salary and how long you have worked for your employer, where the employer is responsible for making sure there is enough money to pay a secure income for life⁹. A defined contribution scheme makes no such promise: the value of the pot can increase or decrease depending on investment returns and the contributions made². In practice, combined contributions by employers and employees have typically been much lower for defined contribution pensions than for defined benefit pensions, averaging 9 per cent of salary against 20.5 per cent¹⁰, which is one reason pots are often smaller than the incomes older final salary schemes produced.

Defined contribution pensions are widespread. An FCA survey found that 28% of people were contributing to a defined contribution pension scheme⁷. The value of your pot at retirement depends on how much you and your employer have contributed and how well the underlying investments have performed⁴.

Workplace, personal and stakeholder pensions

There are two types of workplace pension scheme: defined benefit and defined contribution¹. In a defined contribution workplace pension, your employer chooses a pension provider to invest your pension contributions¹². Group personal pensions, offered through an employer, are also a type of defined contribution pension¹³.

Outside the workplace, a personal pension is a type of defined contribution pension that you arrange yourself⁴, and all personal pensions are defined contribution schemes¹⁴. Stakeholder pensions work the same way: a personal or stakeholder pension is a defined contribution pension scheme, a pension pot based on what you or your employer paid in⁵. The practical difference between these types is who chooses the provider and how the scheme is run, not how the money grows: in every case the pot is invested and its final value is uncertain.

If you stop paying into a workplace scheme, you do not lose what is already there: if you stop paying into the scheme, you will still get that pension when you reach the pension scheme's age¹⁵. What happens to a workplace pension when you leave a job is covered in its own guide, and the rules for personal pensions and stakeholder schemes are set out separately.

Contributions and tax relief

For a defined contribution workplace pension, minimum contributions are set at 8% of your qualifying earnings¹⁶, with at least part of that coming from your employer. Contributions paid into a pension attract tax relief, which is one of the main reasons pension saving is treated favourably compared with other savings. The relief covers not only contributions but also relief on investment returns and the tax paid in retirement, net of the 25% tax-free lump sum¹⁷.

The scale of this support is large. Official statistics show that of the Income Tax relief on total pension contributions, 54% was relieved on contributions to defined contribution schemes in the 2023 to 2024 tax year¹⁸. How the relief actually reaches your pot depends on how the scheme is run: relief at source or net pay work differently, and higher-rate taxpayers may need to claim part of their relief themselves. The dedicated guide to pension tax relief explains the mechanics, and there are separate pages on claiming higher-rate relief, tax relief for Scottish taxpayers and the annual allowance that limits how much you can pay in each year with relief.

Contributions can also be made through salary sacrifice, where you give up salary in exchange for a pension contribution, which changes how the tax and National Insurance treatment works.

You carry the investment risk: how your pot is invested

The defining feature of a defined contribution pension is that you, not an employer, carry the investment risk. Your pension is put into investments, such as shares, by the pension provider, so the amount you have in retirement also depends on how investments perform¹³. The value of the pot can increase or decrease depending on factors including investment returns and the contributions made².

Most workplace schemes put members who do not make an active choice into a default fund. When you save into a defined contribution pension scheme, your money is typically invested in higher-risk assets, which offer higher potential returns, to help the pot grow¹⁹. As you approach your retirement age, many schemes gradually move your money into lower-risk investments, with lower returns, to protect your savings from sudden market changes¹⁹. This gradual shift is known as lifestyling, and funds that do it are called lifestyle funds. Some pension schemes gradually move your money into lower-risk investments as you get nearer retirement age¹.

Lifestyle funds are usually linked to a target retirement date, often your expected State Pension age unless you tell the provider otherwise. That matters because the fund's plan for your money may not match your own: if the fund is de-risking on the assumption you will buy an annuity at 65 but you intend to stay in drawdown into your seventies, the fund's strategy and your plans have drifted apart. Keeping your target retirement date up to date with your provider is therefore part of managing the pot.

Charges are the other thing that quietly shapes the pot's value. The pension scheme provider investing your pension may charge you, often an amount based on the value of the pension¹. Because charges are deducted year after year from a pot that is itself invested, their effect compounds over a working life in the same way investment returns do. The rules on workplace pension charges and the charge cap limit what can be charged in most automatic enrolment schemes.

When you can take your money: 55, rising to 57

You cannot take money from your pension until you are at least 55, rising to 57 in 2028, but you can do so at any point after that⁶. The change has a precise date: the minimum access age rises to 57 on 6 April 2028¹⁶. Taking money is not the same as retiring: you can access the pot while still working, and you can leave it untouched for as long as you like.

The flexibility dates from the pension freedoms introduced in April 2015, when people aged 55 and over with a defined contribution pension became able to choose what to do with their money²⁰. Before that, most people were effectively pushed towards buying an annuity with their pot.

There are limited exceptions to the minimum age. If you are retiring early due to an illness that is likely to affect your life expectancy, some providers may boost your pension²¹, and the rules on taking your pension early because of ill health are covered in detail elsewhere. The age at which you can take a workplace pot is separate from your State Pension age, which is covered on its own page.

Lump sum, drawdown or annuity: your options for taking the money

Once you reach the minimum age, a defined contribution pot can be used in several ways. You can take a scheme pension, buy an annuity, or draw an income directly from your pension fund as a drawdown pension⁵. In practice the main options are:

• Leave the pot invested and take nothing yet, or small withdrawals as needed.
• Pension drawdown, which allows you to keep your pension invested and draw out income as and when you wish. You can take out as much as you want, although this money will be subject to income tax⁶.
• An annuity, which converts part or all of the pot into a guaranteed income for life⁵.
• Lump sums taken directly from the pot, with each withdrawal partly tax-free and partly taxed as income.

Each option carries a different balance of risk. Drawdown keeps the money invested, so its value can rise and fall until you take the money, which means your retirement income is not guaranteed⁶. An annuity gives certainty, but the income you get depends on the size of your pot and annuity rates when you buy, and money used to buy a basic annuity cannot be recovered or passed on flexibly. Money taken as lump sums stops growing once it is withdrawn.

Taxation is what catches many people out. Withdrawals above the tax-free element are added to your income and taxed under the normal rules, which is why large single withdrawals are often hit with emergency tax at first. The guide to how pension income is taxed covers this, and Pension Wise offers free guidance on the options before you commit.

Tax-free cash: 25% up to £268,275

Normally when you retire you take some of your pension pot as a tax-free cash lump sum¹. If you have a defined contribution pension and are 55 or over, you can take up to 25% of the pot as a tax-free lump sum, up to a maximum of £268,275²². The maximum applies across all your pensions, not to each one separately⁶.

The 25% can be taken as a single lump sum, or used piecemeal: with drawdown or lump-sum withdrawals, each withdrawal is treated as 25% tax-free, with the rest taxable as income. The detailed rules, including the lump sum allowances that cap tax-free cash and what happens if you have protected rights from before the lifetime allowance was abolished, are covered in the guide to tax-free cash from your pension and the page on the lifetime allowance.

Investment pathways for drawdown

If you go into drawdown without making an active investment choice, providers must offer you a set of ready-made options called investment pathways. You can choose your own investments, ask a financial adviser to manage them, or ask your provider to choose for you based on your preferences²³.

The rules define four pathways, matching what you plan to do with the money²⁴:

The pathway you are offered depends on the answer you give, so it is worth thinking through your intentions before you are asked. A pathway is a default, not advice: it invests the money in line with your stated plan but does not check whether that plan is realistic or whether the pot will last. How providers run these funds is covered in the guide to taking an income from your provider.

Moving or combining pension pots

Pension consolidation is where you bring multiple pensions together by transferring them into one provider or scheme²⁵. You can usually transfer or consolidate your pensions at any point, unless the scheme rules list restrictions²⁵. Transfers can also happen after retirement: in some cases it is possible to transfer to a new pension provider after you have started to draw retirement benefits²⁶. A transfer means moving money from one personal pension to another, or from a personal or workplace pension to a self-invested personal pension (SIPP), a small self-administered scheme (SSAS) or a qualifying recognised overseas pension scheme²⁷.

Whether combining pots is worthwhile depends on what you gain and what you give up. Transferring a defined contribution pension to a different scheme might save you money if the other scheme has lower fees, give access to different investment options, and give more options for taking your money²⁵. Against that, you could lose valuable benefits, such as guaranteed annuity rates or exit penalties on older policies²⁸. The comparison between combining pots or keeping them separate sets out the trade-offs, and the risks are covered in what are the risks of transferring my pension?.

Transfers out of defined benefit schemes are a different matter, with their own safeguards: some defined benefit schemes might not allow transfers out after your pension has started paying out, within a year of reaching normal retirement age, or if you have an unfunded public sector scheme like the NHS or Teachers' Pension Schemes²⁵. The rules on transferring out of a final salary pension and when advice is required to transfer are covered separately.

What happens to your pension when you die

With a defined contribution pension, you can choose a nominated beneficiary who will inherit the money²⁹. Money left in a defined contribution pension can be left to anyone you nominate²⁵. You record this by filling in or updating an expression of wish form, either by logging in to the online account for each pension you hold or by contacting the scheme directly²⁹. This is separate from your will, and keeping it up to date matters because the scheme uses it to decide who receives the pot.

The tax treatment depends on your age when you die. If you die before you reach the age of 75, you can usually pass your defined contribution pension tax-free to a nominated beneficiary²⁹. If you die aged 75 or over, your beneficiaries will normally pay income tax when they withdraw money from your pension²⁹. In all other cases, including if you die after age 75, your pension usually cannot be inherited tax-free, and the inherited amount is normally added to your beneficiary's other income to calculate how much Income Tax is due²³.

This area is changing. From 6 April 2027, unused pension funds and death benefits are brought into the scope of Inheritance Tax³⁰. From April 2027, regardless of your age when you die, inheritance tax may be charged on money left in your pension if the value of your overall estate exceeds the tax-free allowance³¹. Any unspent funds in drawdown or taken as lump-sum withdrawals will count towards your estate for inheritance tax purposes from 2027³¹. The guides to pensions and inheritance tax and what happens to your pension when you die cover the detail, including how to nominate a beneficiary.

Protection if a pension provider fails

A defined contribution pot is not protected by the Pension Protection Fund, which exists for defined benefit schemes. If the employer sponsoring a defined benefit pension scheme becomes insolvent, the PPF assesses the scheme to see if it can enter the fund³², and it provides compensation in place of the promised pension if the scheme is eligible and lacks the funds⁹. The PPF was set up in 2005 to protect members when the employer and its pension scheme can no longer afford to pay promised benefits³³. Occupational schemes may be protected by the PPF³⁴; defined contribution pots are not.

For defined contribution pensions, the protection that exists is the Financial Services Compensation Scheme. If your pension provider was authorised by the Financial Conduct Authority and cannot pay your pension, you can get compensation from the FSCS¹². The FSCS can only protect you if the FCA has authorised your pension provider³⁵. FSCS protection also covers pension advice: if you received bad advice and the adviser fails, FSCS may pay compensation³⁶. The comparison of PPF vs FSCS protection sets out which applies to which kind of pension.

Two things matter in practice. First, the FSCS compensates for provider failure and bad advice, not for investment performance: a pot that falls in value because markets fell is a loss you carry, not one the scheme covers. Second, if your employer goes out of business, a trust-based defined contribution scheme still pays your pension, but the pot might be reduced because administration costs are paid from members' pots¹².