Putting money in
Someone making contributions to a final-salary scheme will get income tax relief at their marginal rate, and this is no different for defined contribution (DC) schemes. However, higher rate taxpayers (with taxable income of over £41,450 for 2013-14) may need to claim part of the relief separately through a tax return. Many employers operate “salary sacrifice” arrangements for DC schemes, which also enable you to receive relief from National Insurance contributions. In most instances, this is very tax-efficient and represents a clear advantage in having a DC scheme.
Managing your pension
Your contributions are typically invested in stock-market based funds. You’re normally free to choose the funds used, but you have the option of remaining in the default fund (although this may be quite inappropriate). The size of your pension fund at retirement will be greatly influenced by the funds selected, so ongoing monitoring and reviewing is important. Many people fail to do this, throwing their retirement plans into disarray of markets fall close to their planned retirement date. Accepting poor investment returns and potentially excessive charges often means working for much longer than would have otherwise been necessary.
With a final-salary scheme the main decision to make at retirement is whether to give up some of the pension income for a lump sum. There is much more flexibility with a DC scheme, but it can also be much more complicated. Up to a quarter of the DC pension pot may be drawn as a tax-free lump sum at any time from age 55 onwards, but the remaining 75 per cent must normally be used to provide a regular income throughout retirement. Most people use their pension pot to buy an annuity, which then guarantees payment of a set income for life. Annuity rates are at historically low rates, however, and so the alternative option of “income drawdown” is increasingly popular. This normally involves leaving the pension pot invested while drawing a regular income from it.
A final-salary scheme requires little or no management during an employee’s working life and can usually be relied upon to provide generous retirement benefits. Although a DC scheme is also a pension, it is quite a different beast and it’s not enough to take the approach of “I am in the scheme and so have done enough”. Consequently professional advice is recommended, whereas this may not have been necessary with a DB scheme.
• Richard Johnston is a chartered financial planner at Murray Asset Management