Become a pensions expert in five days, day two

Today I'm looking at defined contribution pensions. They're simpler than they sound.

In the first part of this guide I looked at the government's basic state pension and also at final salary pension schemes. Here's a one sentence summary: Don’t rely on the State Pension; final salary schemes are great if you have one!

If you don't have a final salary pension, the next step is to see if you have a defined contribution pension.

Defined contribution pensions

Many people have these schemes. The basic idea is that you and/or your employer save money into a pension pot each year. That money is then invested and will hopefully grow.

Then, when it's time to retire, you normally use the money in your pot to buy an income in retirement from an insurance company. We’ll look at this stage in more detail in a later article.

Defined contribution pensions (a.k.a money-purchase pensions) can be divided into four sub-groups:
personal pensions, stakeholder pensions, group personal pensions, and self-invested personal pensions or SIPPs.

1. Personal pension

A personal pension is a scheme into which holders usually pay a regular amount or a lump sum. The payments go into an investment fund, usually run by a financial organisation such as a bank or insurance company.

This pension provider will then invest the money on your behalf. The final value of your pension fund will depend on how much you've contributed, and how well the fund's investments have done. The pension provider will charge you for setting up and running your pension.

I think personal pensions are a great option for lots of people. They may work well for you if you're working but you're not in a salary-related scheme (see part one). They're also good if you're self-employed.

2. Stakeholder pension

A stakeholder pension is a type of personal pension which has to meet certain government rules. Basically these pensions are supposed to be flexible, secure and offer value for money.

3. Group personal pension

This is a type of personal pension organised via your employer.

Employees contribute to individual personal pensions which are then grouped together and managed by a pension provider of the employer's choice.

Some employers choose to contribute to these schemes alongside contributions from employees. Some employers even match employees' contributions pound-for-pound. If that's on offer at your work, join the scheme! It's basically free money....

4. Self-invested personal pension (SIPP):

A SIPP is another type of personal pension - but you have more control over it as you can pick your investments from a wide range of options.

In some ways it's a bit like an ISA because it's a vessel into which you put your chosen investments. And like an ISA, you don't have to pay Capital Gains Tax on any profit you make.

I have a SIPP myself and I love it as I enjoy making investment decisions. Even if you're not interested in investment as a topic, I think a SIPP is still the best option for many people. All you need do is put your money in a stock market tracker fund. Simple.

Jargon

Before I finish, I just want to explain one more bit of jargon. You may have heard the expression ‘defined benefit’ pension. Defined Benefit is an umbrella term that includes ‘final salary’ and ‘career average’ pensions which I discussed in part one of this series. I’m returning to them now because defined benefit pensions are the opposite of defined contribution pensions.

With a defined contribution pension, you’re paying in a defined payment each year – e.g 4% of your salary. With a defined benefit pension, you’re getting a defined benefit for each year of your retirement – e.g 40% of your career average salary.

In part three of this series, I look at annuities and other ways to turn your pension pot into an income.

More:  Become a pensions expert in five days | The best Sipp for your retirement