A short guide to pension death benefits
Updated: Apr 16
This is the third in a short series of blog posts this week which will explore the often confusing world of pensions in a bit more depth. You can read the first two posts here and here. In this post, we will explore what happens to your pension benefits or pension wealth after you’ve gone.
Most of us don’t like thinking about this subject too much. However, the ‘death benefits’ available from pensions – that is, how your family and loved ones can benefit from your pensions when you die – can be complicated. The way that you decide to take your pension will affect who you can leave your pension to, how much they’ll get, and how long they get it for. This is important for several reasons. For instance, most of us will want to ensure our partners or children will be financially secure after we’re gone. Or you may want your money to pass to somebody else. You may also want to make sure that more of your money goes to the people you want it to, without a big tax bill. This can be particularly important if you feel there is a chance your loved ones will have to pay Inheritance Tax on your estate. Pensions offer a great way to pass on wealth to your loved ones when you are no longer around, as any wealth held in pension arrangements is usually outside of your estate. As this wealth is outside of your estate, it is not subject to Inheritance Tax. So, let’s talk death benefits.
75 is the magic number Specifically, when you reach age 75. This is because, when you reach age 75, the rules around pensions change. For instance, any contributions you make to a pension from age 75 no longer benefit from tax relief – and many pension providers will not allow you to make contributions at all from age 75. One of the more significant rule changes at age 75 is the tax treatment of pension benefits on death for defined contribution, or money purchase, pensions. Put more simply, with most types of pensions, whether you die before or after age 75 affects whether the person you leave your pension benefits to pays income tax on these benefits or not. If you die before age 75, any money or pension rights can usually be paid to a dependent free of income tax. However, if you die once you have reached age 75, any money or pension rights will be subject to income tax at the highest rate the recipient pays. So, 75 is the magic number, as it affects whether the recipients of any pension wealth you hold in defined contribution or money purchase pension arrangements pay income tax on these benefits or not. However, the way you take your pension now also affects who you can leave your pension to, and how much of your pension benefits or rights they’ll receive when you’re gone. So let’s run through the different ways of taking pension benefits when you are alive, and how this affects the potential death benefits available.
Annuity death benefits An annuity policy is a way of purchasing guaranteed income when you retire. In exchange for a lump sum of cash, the annuity provider – usually an insurance company – will agree to provide you with income, usually for life. If you purchase an annuity on a ‘single life’ basis, this means that the income will cease to be paid when you die. If you purchase an annuity on a ‘joint life’ basis, this means you can choose a ‘second life’, which is often a partner but can be anybody you choose when you buy the policy. This second person will then continue to receive income from the annuity policy after you die. This may be for the remainder of the second person’s life, for instance if the joint life policy was agreed for a partner of a similar age, or may be for a set term or until a specific age, for instance if the joint life policy was agreed for a child or a younger partner. This will depend on the terms you agree when you purchase the annuity policy. You can also choose to include a guarantee period when you buy the annuity policy, regardless of whether you choose a single or joint life policy. If you choose a guarantee period at the outset, and you die within this guarantee period, then the policy will continue to pay income to your named beneficiary until the end of the agreed guarantee period. In both instances, the beneficiary of your annuity policy will not pay income tax on the income they receive from your pension after your death if you die before age 75. However, if you die on or after your 75th birthday then the beneficiary of your annuity policy will pay income tax on the income they receive from your pension. So, annuities are great for providing you with guaranteed income during your lifetime, and if you take an annuity policy out on a joint life basis then this ensures your spouse or partner continues to receive the income from the annuity policy for the rest of their life. This is valuable, as it removes the risk of running out of money. You can also set a guarantee period at the outset, which ensures that, in the event of your death within the specified period after taking out the policy, income will still be paid to the person you nominate. However, it is important to note that an annuity policy involves you exchanging a lump sum for income – so you buy a policy. This means that the pension put used to purchase the policy no longer exists. As such, while annuities provide a great means of ensuring continuing income for the whole of your life, and potentially the life of a partner or spouse, they may not offer the most effective means by which to pass wealth on after you die. For instance, if you take a single-life annuity with no guarantee period, then the income simply stops upon your death. Even if taken on a joint life basis or with a guarantee period, the available benefit after you die is typically restricted to a continuing income only.
Drawdown death benefits Instead of buying guaranteed income through an annuity policy when you retire, you can instead choose to leave your pension pot invested and take income flexibly, as and when you need it, via a drawdown arrangement. As your money remains invested within a pension arrangement, instead of being used to purchase an annuity policy, this means there is far greater flexibility both during your lifetime and after you’re gone. This greater flexibility means you can leave your remaining pension pot when you’re gone to a partner, dependent, or another person you nominate. The person you leave your pension to is then able to take this money either as a lump sum, as regular income, or flexibly. A dependent or nominee can take regular income after your death via a dependent or nominee’s annuity policy, or can access money flexibly by entering a dependent or nominee’s flexi-access drawdown arrangement. This means drawdown arrangements offer the ability to pass lump sum wealth on after you die, which should be outside of your estate for Inheritance Tax purposes. This also offers the potential for the person or people you want to receive your pension wealth after you’ve gone to subsequently pass on any remaining wealth to further generations after they’ve gone too – and as this wealth remains within pension arrangements this should not be included in the estates of anybody within this chain. For this reason, drawdown arrangements offer the greatest potential to pass pension wealth down the generations tax-efficiently. However, there is a but. As pension wealth held within a drawdown arrangement remains invested, and is not exchanged for guaranteed income, this means it remains exposed to investment risk. The value of investments can go down as well as up, and you could lose capital. It also means you remain exposed to the risk that any income or withdrawals you take flexibly from your drawdown arrangement during your lifetime exhaust the pension pot while you are still alive. Put simply, drawdown arrangements offer the most flexibility and the greatest potential tax-efficiency, but this only applies if there is anything left to pass on when you die! The magic number of 75 also applies with drawdown arrangements. If you die before age 75, the person you leave your pension pot to will not pay income tax when they take money from your pension. If you die once you have reached 75, the recipient will pay income tax on any money they take from your pension pot.
Leaving cash behind Another option is to simply take money out of your pension while you’re alive. This is known as crystallising funds. You could take your cash in chunks or you could take your whole pension pot in one go, using UFPLS. As you are taking money out of pensions, this gives you complete flexibility, as you can pass it on to whoever you like via your Will, and the beneficiary can, in turn, also pass this wealth on in any way they wish when they are no longer around, via their Will - but this comes at a cost, as any money taken from a pension arrangement will form part of your estate when you’re gone. This means that the money you have taken from your pension will be included when HMRC calculates whether any Inheritance Tax is due. Put simply, taking wealth out of pensions means you no longer benefit from the tax privileges pensions offer. By contrast, any money or pension rights that remain within a pension when you die will not usually form part of your estate, and will be excluded by HMRC when calculating any Inheritance Tax liability. This means pensions offer tax efficiency not only during your lifetime, but when you’re gone too.
If you have a different type of pension Most pensions today are defined contribution, or money purchase, pensions. This means the contributions made to your pension are invested, and your income in retirement depends on how these investments perform. Any private pensions, such as personal pensions or stakeholder pensions, will be defined contribution, and most workplace pensions today are also defined contribution. Defined contribution pensions offer the greatest potential flexibility when you’re gone, as you can choose who you leave your money to. These types of pensions also offer the greatest potential tax efficiency, as any money or pension rights you leave for loved ones is tax free if you die before age 75. By contrast, other forms of pensions which are not money purchase arrangements, like the state pension or any defined benefit pensions like final salary arrangements, have different rules. These different rules apply to how you can leave death benefits, who you can leave them to, how much they’ll get, and how much tax they’ll pay.
Final Salary & Defined Benefit pension death benefits Defined benefit pensions provide guaranteed income for life, usually on a final salary or career average basis. Most defined benefit pensions also provide death benefits, although this will depend upon rules specific to your pension scheme. If you die before your pension is in payment, most defined benefit schemes will provide a lump sum to your dependent, typically a surviving spouse or civil partner. This lump sum will usually be a set amount or a multiple of your salary, and crucially this sum will be paid to your dependent tax-free. If you die after your pension is in payment, most defined benefit schemes will provide an ongoing income to a dependent or dependents. However, this will depend on the specific rules of your pension scheme. This income will also be taxed at your dependents’ marginal rate of income tax, regardless of your age when you die. The magic number of 75 does not apply! Some defined benefit schemes will only provide a ‘spouse pension’, payable to a spouse or civil partner, typically of 50% of your pension rights. This is usually paid for the remaining lifetime of your surviving spouse or civil partner, although any pension rights can be affected if your surviving spouse or civil partner is substantially younger, or if they remarry. Other defined benefit schemes will also provide income after your death to a child or children, typically of 25% per child. This is known as a ‘childrens pension’. However, this will usually only be provided to a child under the age of 23, and any entitlement will cease when your child reaches age 23. Your pension scheme may continue providing an income after age 23 if the scheme’s Trustees deem that your child remains dependent due to physical or mental impairment. As such, while defined benefit pensions provide valuable rights when you are alive, the death benefits provided by defined benefit pensions are more restrictive, and often less tax-efficient, than the death benefits provided by defined contribution, or money purchase, pension arrangements.
State pension death benefits Depending on when you reached or will reach your state pension age, some of your state pension rights may pass to your surviving spouse or civil partner when you’re gone. However, there is no entitlement to any of your state pension rights for any children or other dependents, such as a partner who is not a spouse or civil partner. Whether your surviving spouse or civil partner will have any entitlement to your state pension rights will depend on whether you die before or after you have reached state pension age. It will also depend on whether you reached state pension age before or after 6 April 2016, whether your surviving spouse reached state pension age before or after 6 April 2016, whether your surviving spouse is entitled to a full state pension in their own right, and other factors. Any entitlement for a surviving spouse or civil partner to your state pension rights after you die is a complex topic which will depend upon a range of factors specific to you. However, it is fair to say that, in most instances, any benefit from your state pension is likely to end on your death. As such, state pensions do not offer any substantial scope to pass on benefits to your loved ones when you’re gone.
How to nominate a beneficiary While you can choose who to leave your estate to via your Will, any money you hold in a pension when you die is typically deemed to be outside of your estate. This has significant tax advantages, as the money you leave in pensions won’t usually be considered when calculating any Inheritance Tax liability. However, it also means that your wishes as expressed in your Will do not apply to any money you have left in pension arrangements. As such, you should always nominate a beneficiary or beneficiaries or complete an ‘Expression of Wishes’ form, regardless of the pension arrangement you have. This will help the trustees or administrators of your pension arrangement determine who to pay your money or pension rights to after you’re gone. You should also ensure that you provide a new Expression of Wishes if your wishes change. You should note that an Expression of Wishes is not binding on pension scheme administrators, as providing a binding instruction makes it very likely the benefits would be subject to Inheritance Tax. The administrators ultimately have discretion over who to pay benefits to, and it is precisely because of this discretion that wealth held within pension arrangements does not typically form part of your estate, and is not subject to Inheritance Tax, on your death.
Summary Pensions are financial arrangements that benefit from specific tax privileges. These privileges mean pension wealth held in defined contribution arrangements can pass to your surviving spouse or partner, or to children and potentially to whoever you want to benefit, tax-free if you die before the age of 75. In addition, and significantly, any pension wealth or pension benefits you retain upon your death can usually be passed on while remaining outside of your estate, and therefore do not count towards your estate for Inheritance Tax purposes. However, when it comes to death benefits, not all pension arrangements are equal. Some arrangements, such as drawdown, offer the means to pass wealth down the generations, while other arrangements, such as final salary and defined benefit pensions, annuities, and the state pension, often cease to pay benefits upon your death or the subsequent death of a spouse or partner. While drawdown arrangements offer the greatest flexibility in death benefits, this comes at the cost of a lack of guarantees while you are still alive – and the options available via drawdown to pass wealth on only applies if there is any wealth left to pass on! This blog post is intended to provide generic guidance on pension death benefits, and does not constitute financial or pension advice. While pension death benefits are important, so too are the benefits different pension arrangements can provide to you during your lifetime. A good financial adviser will consider all factors before making any specific recommendation to you. You should always seek appropriate professional advice or assistance before making any major financial decisions. #pensions #retirement #financialadvice #retirement planning #deathbenefits
IMPORTANT NOTES: This blog post is not financial advice and is not specific to any individual. This article is intended as generic guidance and comment only, and does not constitute any form of financial or investment advice or recommendation, which is always specific to individual needs. You should not take any actions on the basis of this article, and should take appropriate professional advice instead. This post was published in April 2020. Legislation and policy may change over time. All blog posts are written by Dylan Roberts in a personal capacity and do not necessarily reflect the views of Lighthouse Financial Advice Ltd, Lighthouse Group, Quilter Financial Planning, or Quilter plc.