What happens to my pension after death?

Graeme Davies

I have two pensions, a final-salary one to which I no longer contribute and a defined-contribution company pension to which I do contribute. This current pension offers generous death-in-service benefits, but I don’t know how this is normally paid out to dependants or if there are restrictions on the amounts that can be paid. I would also like to understand more about what happens to my pension pot if I die after I have retired and started receiving pension payments.

S Mather

Martin Haggart, Technical Manager Pensions at Aegon, says: With regard to the paid-up final-salary scheme, I would urge the member to review the benefits payable in the event of their death as the scheme may provide only a minimal level of benefits on death in comparison with the benefits that would prospectively be payable at retirement (and they may wish to take action to protect against any possible loss with life insurance or an alternative course of action).

For example, the final-salary scheme may not provide any lump sum death benefit (other than perhaps a return of the member’s own contributions with or without interest) and instead will prospectively pay a specified level of pension to a spouse or dependant, usually based on a percentage of the member’s pension. Any pension benefits payable to a spouse, civil partner or dependant from a final-salary scheme will be taxed in the hands of the recipient(s) regardless of whether death occurs before or after age 75. 

If there is any lump sum death benefit payable it would be paid tax-free if death occurred before age 75 and would be paid to the beneficiaries chosen by the scheme trustees at their discretion. The level of any such lump sum is effectively unlimited (although likely minimal as above) but any excess over the available lifetime allowance would be subject to a tax charge on the recipient beneficiaries. 

The scheme rules will set out the benefits payable in the event that death occurs after benefits have been taken. Often a guarantee payment period of anything up to 10 years will have been included with the member’s pension, in which case the pension instalments will continue to the end of that period. In addition, the scheme may provide for a pension to be paid to a spouse, civil partner or dependant usually based on a percentage of the member’s pension at the date of death.

In a defined-contribution scheme, the scheme rules will determine exactly what death benefits are available. This may be a lump sum death benefit, an income available to beneficiaries or both. The pension freedoms introduced death benefit flexibility in April 2015 allowing schemes to pay income on death to a wider class of beneficiaries than had previously been the case, in addition to the continuation of lump sum death benefits. It needs to be remembered that while the legislation included a permissive override, allowing schemes to pay more flexible benefits even if their scheme rules had not been updated, it did not oblige schemes to offer flexibility, and many legacy schemes do not do so. 

It may be that the specific scheme rules will allow full death benefit flexibility and that the beneficiaries chosen by the scheme will have the choice of using the uncrystallised funds allocated to provide them with benefits to take a lump sum, or buy an annuity, or to remain a member of the scheme and draw an income from the fund (drawdown). If choosing to remain in drawdown, the beneficiary may be able to nominate their own beneficiaries to receive benefits in the event of their own subsequent death.

Alternatively, the scheme rules may only allow a lump sum death benefit to be paid to beneficiaries chosen by the scheme administrator. If the member has chosen to nominate any lump sum death benefits payable from the scheme to be paid to a trust which has been established outside of the pension scheme, and assuming the scheme chooses to follow such a nomination, then the lump sum death benefit would be paid to the trustees who would then provide benefits to beneficiaries in accordance with the trust provisions.

Any lump sum death benefit, and any funds used to provide income to a chosen beneficiary (if this benefit option is available) from the uncrystallised funds, are effectively unlimited although they will be tested against the member’s lifetime allowance, which sets an overall limit on the amount of tax-advantaged pension savings for any individual across all their registered pension schemes. Any excess over the available lifetime allowance would be subject to a tax charge on the recipient beneficiaries. Assuming the benefits are within the lifetime allowance, any lump sum death benefit and income payable would be tax-free to the beneficiaries if death was before age 75. Benefits payable on death after age 75 will normally be taxed at the recipient beneficiary’s marginal rate where the beneficiary is an individual.

The position on death after taking benefits depends on the choices that the member makes at the point they take benefits and given that this will include the variables of a tax-free lump sum, the possible purchase of an annuity (and the features chosen) and remaining in the scheme and taking drawdown income.  

As far as inheritance taxis concerned, it is possiblethat HMRC may seek to levy a tax charge if the member has, while in the knowledge of ill health, either paid a large contribution to either scheme or has effected a pension transfer of their pensionbenefits and died within two years of the contribution or transfer payment.

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