Death benefits options differ dramatically between defined benefit schemes and defined contribution schemes, with the former not having evolved much over the years when it comes to spouse, civil partners and dependent children.
While DB schemes have remained largely the same, DC schemes have changed significantly with the last major change in 2015.
Pension freedoms were the biggest change to pensions in a generation, if not ever. Since 2015 individuals over the age of 55 have had full access to their pension at only marginal rate taxes – and can pass on a pension tax free.
Speaking on the change, Claire Trott, divisional director – retirement and holistic planning at St James’s Place Wealth Management, says the last change tore up all the previous options and made it “a case of virtually anything is possible”.
She adds: “However, as with all of these things schemes will apply their own restrictions, many of which will be because they are unable to administer the wider options.
“The options include: beneficiaries drawdown or lump sums with restrictions generally removed with regards to who a beneficiary can be. It is also possible to pass the funds down multiple generations where beneficiaries drawdown is used.”
Trott explains that the taxation of the death benefits in DC schemes was the most significant change.
Benefits payable where the deceased was under the age of 75 are paid income tax free, with the odd exception for cases where benefits are not settled within two years.
“Where the deceased was over the age of 75 then the benefits are taxed in the hands of the beneficiary as income under PAYE,” she says.
“There is also the taxation of payments to trusts, which is a flat rate of 45 per cent if the deceased was over 75 but there is a credit for the beneficiary for this tax when the benefits are distributed from the trust.”
As with all of these things schemes will apply their own restrictions
Overall, the consensus was that the rules on pension death benefits have not changed much in recent years and remain extremely favourable to savers and their families.
Fiona Tait, technical director at Intelligent Pensions, explains that individuals in occupational schemes will have their benefits outlined in the scheme rules.
“Prior to retirement, this usually takes the form of a lump sum based on contributions or earnings during employment plus any spouse's pension, and in some cases a pension may also be payable to any financial dependents such as minor children,” Tait explains.
“Following retirement there is usually only a spouse's pension with the balance of unpaid income in cases of early death.”
For those in workplace or personal pension arrangements, the full value of the fund is available to be paid and is most often paid out as a lump sum.
It is however possible for beneficiaries to opt for a guaranteed income or to simply take over the plan in their own name.
A complex area
Meanwhile, other industry experts argue that the existing rules on death benefits from registered pension schemes are an extremely complex area.
Stephen McPhillips, technical sales director at Dentons, explains that in general terms, death benefits are usually distributed at the “absolute discretion of the scheme trustees”, to the member’s beneficiaries free of inheritance tax.
“Whether any other taxes might apply depends on the age of the member at date of death, the member’s lifetime allowance position, whether or not the death benefits are distributed/designated within two years of the member’s death and the nature of the recipient – for example, a dependant, a nominee, a trust, a charity, the member’s estate and so on,” he says.
“Broadly, death benefits are viewed as an attractive feature of pension schemes and the introduction of pension freedoms in 2015 greatly increased the flexibility afforded to scheme members. The ability to pass pension wealth down through the generations (to 'nominees' and 'successors') is a welcome evolution of the rules around death benefits.”
Meanwhile, Neil MacGillivray, head of technical support at James Hay Partnership, notes that DB death benefits are normally determined by individual scheme rules.
Discussing how they work, he says for death in service (DIS) there will generally be a dependant’s pension, covering the individual’s partner and any other dependents, such as children.
There is also likely to be a lump sum death benefit, with probably the most common being a multiple pensionable salary. If there are no dependants, then only a lump sum would be payable.
Another scheme of DB would be death in retirement, which would again normally mean a dependant’s pension with perhaps the most common being 50 per cent of the member’s pension, although there is no limit on the amount of pension that can be paid as a dependant’s pension if the member died, either pre or post-retirement, before reaching age 75.
Scheme rules determine whether there is any lump sum death benefit payable in the event of the death of the member in retirement.
“The perceived downside to DB death benefits is that the pension ends with the death of the last surviving dependant," notes MacGillivray.
"However, it should be emphasised that the payment of a dependant’s pension does not result in a benefit crystallisation event."
He adds: “Therefore, in the instance of a dependant’s pension, there is no test against the deceased member’s LTA. If paid within the relevant two-year period, it would only be the DB lump sum death benefit that is tested against their LTA.”
Money purchase death benefits are also determined by the scheme rules. For example, some legacy products may only pay out a lump sum if the individual dies before taking benefits, with no right to a dependent's pension.
Similarly, if the member had opted for a single life annuity, with no guarantee, this would end on their death.
Change in rules
The introduction of pension freedoms has made it significantly easier for members to provide for beneficiaries following the death of the member.
In some respects, the change in rules has also meant that previously taxable death benefits are no longer taxable – for example, payment of death benefits from crystallised funds where the member dies before age 75, which had been taxable previously.
Although this is subject to the member’s LTA position and the nature of the recipient, it can still be seen as a benefit.
MacGillivray explains the various different positions for schemes that follow pension freedom principles.
Uncrystallised rights – those that have not yet come into payment, any dependant, or someone nominated by the member – offers the option of beneficiary’s flexi-access drawdown and/or a lump sum death benefit.
For this, if the member was under the age of 75 at the time of their death, and provided the benefits are paid within two years of the member’s death, the benefits are payable free of tax.
However, the death benefits, in their entirety, would be tested against the deceased member’s LTA, with any excess over their LTA being subject to an LTA charge at the appropriate rate.
For uncrystallised rights where the member was over 75, there is no test against their LTA, but the beneficiary is liable to tax at their marginal rate on anything they withdraw from the funds.
MacGillivray also explains that for crystallised rights, where the member died under 75, a beneficiary’s drawdown fund is free of income tax, as is any lump sum death benefit they took, provided the latter is taken within two years of the death of the member.
For crystallised rights where the member died over 75, the beneficiary’s options are all taxable at their marginal rate when withdrawing any benefit.
These changes in place have meant that significantly more clients are considering utilising other assets before their pensions when taking income.
Trott says this is mainly due to the favourable taxation of death benefits and the IHT benefits of leaving funds within a pension scheme rather than drawing them out.
Similarly, Tait adds: “Since the introduction of pension freedoms it has been possible for beneficiaries to set up a beneficiaries’ or nominees’ pension plan in their own name and to take withdrawals if and when they are needed.
“This has the considerable advantage of preserving the funds within a pension trust, which means they will usually remain outside of the beneficiary’s estate on their death.”
She explains that it also provides options for the beneficiaries to manage the tax position.
“Where a member dies before age 75, benefits are normally paid out free of income or capital taxes, however if death occurs after age 75 the benefits will be taxed at the recipient’s marginal rate.
“Beneficiaries’ drawdown allows the recipient to choose how fast they wish to withdraw benefits and thereby manage their own tax bill, and also allows them to pass the funds on down the generations until they may be paid out tax free.”
Age is nothing but a number
According to the experts speaking to FTAdviser, the complex nature of pensions and death benefits means it should be a question foremost in an adviser’s mind when discussing their pensions.
Tait argues that the question about what clients wish to happen to their fund after their death should always be addressed, at outset and on a regular basis to allow for any changes in their circumstances.
“It does not have to be a very long conversation, but it is a crucial part of any retirement plan,” she says.
Likewise, Gareth Davies, specialist business development manager at Scottish Widows, says it should be an important part of the overall advice proposition when advising pension clients, however he argues that there are many other factors to consider based upon the clients' specific needs and objectives.
“Sadly none of us know when we will die, and [this] means that it has never been more important to have these, sometimes difficult, conversations with your clients as part of your advice proposition,” he says.
“I would suggest that it is worth incorporating a review of the pension nomination form into every annual review, as the client's circumstances and priorities can change.”
He adds: “I would also encourage early engagement with all potential beneficiaries, subject to client agreement, who are named on the nomination form.
"This should be done as part of the nomination advice process at the earliest opportunity, to ensure that you are as well placed as possible to help a family when they are at their most vulnerable and in greatest need of your expertise and support.”
Meanwhile, Dentons' McPhillips explains that death benefits are “a key facet of pension schemes” and, as such, they might be foremost in an adviser’s mind when advising a client on their pension.
He says: “In fact, for some clients, there may be no need to draw any retirement benefits from the pension scheme in their lifetime and the pension scheme is viewed as a death benefit vehicle as part of wider financial planning.
“In addition, death can occur at any time and most members will want some peace of mind that there is provision for beneficiaries in the event of death – whether in the accumulation or decumulation phases.”
Across the pensions market, there are still many schemes that are imposing restrictions for various reasons.
Trott says the issue still remains that you cannot move a pension on death until the scheme holding it has processed the death benefits.
“Therefore, if the scheme doesn’t offer beneficiary’s drawdown then there is no scope to transfer to access if after death,” she says.
“Understanding the scheme options is just as important as ensuring that the client has appropriately completely the expression of wishes and considered if there is a need for the use of trusts.”
She explains that advisers should address the death benefit discussions at the first point that a client makes a pension contribution.
“There can be additional restrictions applied because of legislation if an expression of wishes hasn’t been completed, which can be very frustrating should benefits not be available in the most appropriate format just because a form hasn’t been completed,” she adds.
There are clearly points where death benefits need to be revisited; the usual significant life events such as marriage, divorce and birth of children and grandchildren. But also age 75 where the taxation of benefits changes and the use of a trust may be less appealing, for example.
Yet, McPhillips says death benefits are such an important part of pension schemes that they should be discussed regardless of the age of the client.
“There is an important distinction between clients who have reached their 75th birthday and those who have not. So, the age of the client at the date of death makes a difference.
"However, that should not detract from the fact that death benefits are a fundamental aspect of pension schemes at any age.
“Advisers should also be aware of whether or not clients have accessed pension commencement lump sum by their 75th birthday.”
Likewise, Tait also notes the age of the client should not make any difference to the process with regard to death benefits.
She explains that while it is more likely than not that a client will live to their retirement, there is of course no guarantee.
“When a client dies without a will or any indication of how they would like their benefits to be paid this can lead to considerable delays while the trustees decide on the most suitable option,” she says.
“These cases are also most likely to result in a challenge by individuals who believe they should have benefited and did not. Advisers should ensure that all clients have an expression of wish form in place.”
MacGillivray adds: “It should form an integral part of the advice process no matter what the age of the client is. I’ve certainly come across instances where DIS written under pension legislation has been as high as 10 times pensionable salary.
“While the individual may not have had a significant pension fund, the DIS alone could have resulted in an LTA charge. Similarly, even with what may be perceived as a relatively small pension fund, clarity [and] using a nomination on who any death benefits are to pass to is essential.”
What do you think about the issues raised by this story? Email us on FTAletters@ft.com to let us know