Pension death benefit tax planning
For intermediaries only.
In my experience there’s a great deal of confusion over pension death benefits generally. Many clients have built up their pension savings in a variety of different types of schemes and arrangements over the course of their working lives, from retirement annuity policies, occupational schemes, buyout policies, former rebate only plans, through to modern personal pension tax wrappers sitting on platform.
How many of your clients fully understand what form of death benefits would be payable from each of their pension arrangements, how the benefits would be taxed and who the benefits would be paid to? Even in the simplest example of a personal pension, research suggests only a small percentage of clients understand that the pension scheme (generally) has the discretion to decide how benefits are allocated between the possible beneficiaries. Most believe that benefits will automatically be paid to the beneficiary they’ve chosen on their nominations.
Before the pension freedoms were introduced in April 2015 spousal bypass trusts were all the rage, with a discretionary trust being used to hold lump sum death benefits outside of the taxable estate of the surviving spouse while still giving them access to benefits by being one of the discretionary beneficiaries. Many of these trusts haven’t been reviewed to check if they’re still fit for purpose. It may be there is a desire for more control in the timing of benefits, for example, or perhaps complicated family circumstances that merit the continued
use of the trust.
Other cases may be better served from a tax perspective if the potential beneficiaries have the ability to retain the benefits within a registered pension scheme, and if so the client may need to take action. And even for those cases where a trust is still suitable, the appointed trustees may need specialist advice to understand the complex tax treatment that will apply under the trust once the benefits are paid out of the scheme.
Many clients automatically assume that full death benefit flexibility is available from their existing arrangements. This may be due to the statutory override that was introduced alongside the pension freedoms, allowing schemes to pay flexible benefits even if the scheme rules haven’t yet been updated. It needs to be remembered, however, that this is a permissive override and that schemes aren’t obliged to offer flexible benefits.
Due to the continued focus on the development of platform propositions where full death benefit flexibility is offered as standard, few providers have spent the additional time and resource to track back and make system changes and introduce new procedures to support benefit flexibility under their old legacy arrangements. This is one of the many and varied reasons why it may be appropriate for legacy clients to upgrade to a platform proposition.
Review existing scheme
If the existing scheme or arrangement doesn’t provide the full range of death benefit options to suit the client’s circumstances, and there’s no opportunity to alter the existing provisions, then ultimately a pension transfer may need to be considered. Arrangements such as retirement annuities and most buyout contracts don’t include any element of discretionary disposal (unless the policies have been written under trust) and may be top of the list for review. Transfers should only be considered as part of a full financial review and it should be remembered that any transfers made in the knowledge of ill health may ultimately lead to an inheritance tax challenge by HMRC if death occurs within two years of the date of transfer.
Nominate and regularly update
Having reviewed (and possibly transferred) a client’s pension arrangement to make sure it’s suitable for their needs, it is important to put a death benefit nomination in place and regularly review and update it as circumstances change. This can be done at any time. Again many clients don’t understand why this is appropriate and simply complete a nomination at the outset of the policy and fail to review it again. It’s far more likely that a scheme will exercise its discretionary powers and pay benefits to the right beneficiaries in line with the client’s wishes if the nomination is completely up to date. At the very least, this should be part of every client’s annual review.
Anyone that the client wishes to receive death benefits from the pension scheme should be named on the death benefit nomination form, as that will allow the scheme to offer the full range of benefit options, including income and lump sums. A scheme is able to choose a beneficiary if no one has been named but will generally only offer a lump sum in these circumstances, unless the person the scheme has chosen is a dependant (as defined by HMRC).
Requesting reallocation at point of death
Another advice opportunity is where the client wants his or her beneficiaries to have the flexibility to request that the percentages stated on the nomination form be reallocated to suit the circumstances that exist at the point of death (any such request won’t be legally binding on the scheme but will generally be taken into account when the scheme exercises its discretion). How is that best achieved using the draft nomination form supplied by the scheme?
At the point of death, it’s important that any request from the beneficiaries to change the percentages must be received by the scheme before it exercises its discretion and awards the benefits. Otherwise it won’t be taken into account by the scheme and any attempt after that by a beneficiary to give up part, or all, of the benefits awarded to them may have inheritance tax implications.
And what if the client’s children, grandchildren or other minors are to be nominated for death benefits? On death, will the scheme offer the minor the full range of options (if they’re chosen) or only a lump sum death benefit? Aegon offer income and lump sum options to minors, if chosen under our discretion, under our Aegon Retirement Choices SIPP, One Retirement and Aegon Platform products.
You may wish to seek specific information from each of your clients’ schemes to make sure this option is definitely available, for example:
- How will a minor’s drawdown arrangement be set up?
- Will it be possible to obtain an accurate illustration?
- Who will the scheme take instruction from on investments and benefits payable?
- What verification requirements need to be met when benefits are taken to make sure payments are
made to the right person?
- What process is followed when a chosen minor reaches majority?
The general lack of understanding on pension death benefits presents you with a range of advice opportunities to help your clients and their beneficiaries achieve the best possible outcomes. Reviewing existing legacy schemes or arrangements and existing spousal bypass trusts to make sure they continue to meet your clients’ needs and circumstances is only part of the advice process. Nominations need to be put in place and regularly reviewed and updated as circumstances change. And where there is a desire for flexibility at the point of death, or if minor children are to be nominated, then there are many additional advice issues that need to be factored in.
The information in this article is based on our understanding of current taxation law and HM Revenue and Customs (HMRC) practice, which may change. The tax treatment depends on the individual circumstances of each client and may be subject to change in future.
Transferring or investing your client’s pension may not be the best option for them, you should compare the benefits from their current pension with the estimated benefits of their new pension, including any guarantees and penalties.