Financial Planner Roy Ritchie outlines the different types of pension and how their death benefits work.
“In this world nothing can be said to be certain except death and taxes.”
Over two hundred years later not much has changed. Neither death nor taxes (particularly death) is nice to contemplate, but both must be faced and planned for. Savings and investments are typically distributed according to the deceased’s Will (which is why it is so important to have one), but what about your pensions?
Credit: Nick Youngson - NY Photographic
Well, this will depend first and foremost on the type of pension that you have:
The ‘basic’ State Pension is payable to men born before 6 April 1951 and women born before 6 April 1953. In some circumstances, individuals not entitled to the full State Pension themselves can claim against a deceased spouse’s qualifying years, but there are rules depending on when both the individual and their spouse reached State Pension age.
Under the ‘new’ State Pension, there is no such entitlement, and so if both individuals reach(ed) State Pension age on or after 6 April 2016, their respective State Pension payments will usually cease on death.
Final Salary Pension
A Final Salary or Defined Benefit (DB) pension is a type of workplace pension scheme where the pension a member receives is based on their salary and years of service, rather than the amount of pension contributions paid in. DB pension schemes typically include death benefits, which vary from scheme to scheme.
If you are a member of a DB pension scheme and die whilst you are still employed, your beneficiaries will likely have an entitlement to Death in Service (DIS) Cover. This is a lump sum death benefit usually calculated based on a multiple of the member’s salary on the date of their death. Who a DIS benefit can be paid to is dependent on the rules of the scheme, but in most cases it will be paid tax-free to a dependent, providing that it falls within the member’s Lifetime Allowance for pensions (currently £1.0731m).
If a scheme member dies after they are already in receipt of a pension from the scheme, this income can continue at a reduced rate as a dependant’s scheme pension. In most cases, however, the scheme will only recognise a spouse as a dependent eligible for the pension, and when they too die, the income stops. A dependant’s scheme pension is taxed as earned income at the recipient’s marginal rate of Income Tax.
Money Purchase Pensions
Money Purchase or Defined Contribution (DC) pensions include both personal pensions and ones opened by your employer, where the value of your eventual retirement benefits is dependent on the value of the contributions paid in and any investment growth. These types of pension are generally much more flexible than DB pensions, particularly if the scheme can offer Flexi-Access Drawdown (FAD).
FAD was introduced in 2015 as part of the Government’s Pension Freedoms initiative to give people greater control over their pensions. It is currently available from age 55 and allows you to draw from your DC pension on a flexible basis while the remainder of your pension fund remains invested with the objective of achieving further investment growth. These benefits also extend to the member’s beneficiaries by way of a nominee’s or successor’s flexi-access drawdown pension. Some older pension schemes are not able to facilitate FAD, however, in which case transferring the fund to a newer scheme could be considered.
With these pensions, the scheme member completes a Nomination of Beneficiary/Expression of Wishes form to advise the scheme administrator of who they wish any death benefits to be paid to (although this instruction isn’t binding on the scheme administrator). There can be more than one beneficiary nominated and there are no restrictions as to who these can be. How the death benefits are taxed on these beneficiaries is dependent on the age of the policyholder when they die.
If the policyholder dies before age 75, the beneficiaries are entitled to their portion of the pension fund and, in most cases, it will be free of tax (providing that the Lifetime Allowance of the policyholder is not breached). If the policyholder dies after age 75, any pension funds the beneficiary receives will be treated as income and taxed at the beneficiary’s marginal rate of tax on any withdrawals they take.
As you can see, there are many things to consider when it comes to bequeathing or inheriting pensions. The introduction of greater flexibility regarding pension withdrawals and death benefits can be a double-edged sword, creating much more complex situations to consider than with the straightforward Final Salary pensions of old. Nevertheless, these flexibilities grant the opportunity for more effective tax planning and wealth preservation throughout the generations. It is therefore more important than ever to plan ahead. Always consult with a professional before making any significant decisions regarding your pensions or your estate planning.
Roy Ritchie DipPFS
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Information is based on our current understanding of taxation, legislation, and regulations. Any levels and bases of, and reliefs from, taxation are subject to change.
The scenarios included are for information purposes/general guidance only and should not be interpreted as advised recommendations.
A pension is a long-term investment - the fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available.
The value of investments and income from them may go down. You may not get back the original amount invested. Past performance is not a reliable indicator of future performance.
The Financial Conduct Authority does not regulate will writing.