What are defined contribution schemes?
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Defined Contribution (DC) schemes are
those whereby the company promises to pay some specified level of
contributions into your pension fund. This fund then grows with
investment returns to the point of retirement at which time you will
need to convert this fund to a pension. The key quality of a DC
scheme is that whilst the amount being paid into the fund is known
(i.e. the contributions are defined) the eventual amount of pension
received is not known with certainty. Another frequently used name
for DC schemes is Money Purchase schemes and these terms are
completely interchangeable. DC is exactly the same as Money
Purchase.
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How does a DC scheme work?
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A DC Scheme basically works like this
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the company and/or the member pays contributions into a fund
(normally on a monthly basis as a percentage of salary). The exact
way in which the level o contributions is decided is considered
later on in the guide.
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these contributions are invested until the member reaches
retirement. As a member of the scheme you may or not have control
over how the contributions are invested. This is discussed later
on.
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at retirement the fund is used to purchase a pension
(technically called an annuity) for the
member and possibly his or her spouse. Some of the fund can also
be taken as tax free cash. Again this is discussed later on.
As you can see the basics of a DC scheme are simple. Money goes
in, this money is invested to produce a fund at retirement and then
this fund is used to purchase a regular income (an annuity). DC
schemes do not differ too greatly in terms of how they work. They
all have this basic mechanism however they do differ by the rules
used to determine how much the company pays into the fund on your
behalf, how the funds are invested and what your options are at
retirement.
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The trend towards DC?
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DC Schemes are becoming more popular recently as companies seek
alternatives to traditional final salary schemes the costs of which
have spiralled in recent years. Companies prefer the certainty of
cost that comes with a DC scheme and the lower regulatory burden.
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Read the guide to
investment in the pensions guide. It explains what you need to
think about before investing for your retirement.
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