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Pension savings account for more than 40% of total wealth in the UK*. For many individuals, their pensions pot may even be worth more than the family home. Despite this, people appear to pay more attention to what happens to their non-pensions assets on death via their wills than on how their pensions will provide for their family.

Maybe this is because property and investments comprised in estates is exposed to IHT, while pension savings are generally outside the estate. Whatever the reason, clients should be primarily concerned that all their wealth reaches the right beneficiaries at the right time, and that this is achieved as tax efficiently as possible.

So, how does a client achieve the best outcomes to match their personal circumstances?

Getting the nominations right

A valid will takes care of who gets what from your client’s estate. But most pension death benefits don’t form part of the estate and will not be dealt with by the executors. Instead, the benefits are normally paid at the discretion of the trustees or scheme administrator. However, a death benefit nomination can be made to help guide the scheme trustees/administrators when exercising their discretion.

The scheme rules will determine the range of possible beneficiaries but, typically, members can nominate family and friends, charities, trusts which the settlor created during their lifetime or trusts created in the member's will.

The trustees or scheme administrators will complete their own investigations and use their discretion, but they’ll often follow the instructions in the nomination unless there's good reason not to.

But there’s a lot to consider.

Ensuring all possible options are available

Even where a client is in a scheme which offers all the retirement and death benefit options, this doesn’t mean that all beneficiaries will automatically have all the options available to them.

Dependants will have the choice of a lump sum or a pension (via an annuity or beneficiary's drawdown).

However, nominations are normally required where non-dependant beneficiaries are involved. If a non-dependant hasn't been nominated, they can only receive a lump sum if the trustees or scheme administrator decides that they should benefit. This is because, if the deceased:

• had nominated another individual (or a trust or charity) or
• has a dependant,

then the trustees or scheme administrators cannot allow anyone else to use the funds for pension purposes.

However, the existence of a dependant is only relevant on the death of the original member. It’s not relevant when paying death benefits from beneficiary's drawdown funds.

So, if a non-dependant is to potentially benefit - for example, the member’s adult children - it’s crucial that they’re nominated to avoid what could be a large income tax bill on a one-off lump sum should the member die after their 75^th birthday. The ability to choose beneficiary's drawdown could instead allow the funds to remain in the pension wrapper and provide the flexibility for the funds to be drawn more tax efficiently, as and when needed.

Even if the member dies before age 75 and withdrawals are tax free, the option of retaining the pension in a beneficiary's drawdown account will still protect the fund from IHT and from income tax and capital gains tax on investments. In effect, it acts like an ISA account but with the added benefit of no IHT.

It should be noted that nominated charities and trusts can only receive lump sums.

Make sure the client’s wishes are clear

It's critical that client’s wishes are identified and detailed clearly, to avoid misinterpretation.

Leaving everything to the spouse may appear to be the easy option and difficult decisions on who should benefit can often get kicked down the road.

But the death benefits may provide more than the spouse wants or needs. And it could limit the options available should their spouse predecease them.

Even where the client’s intention is to leave everything to the spouse, it can still make sense to name other beneficiaries who would then also have all the lump sum or income options should the spouse not require all of the benefits.

This can be particularly helpful if the member dies before age 75, meaning that all benefits (within the lifetime allowance) are free of income tax. If the spouse doesn’t need all the benefits, this could be an opportunity to pass, for example, some of the benefits on to the children or grandchildren, also free of income tax. However, if the spouse inherits everything and then dies after reaching age 75 (a strong possibility given UK life expectancy), any death benefits paid to their beneficiaries would become subject to income tax. The tax position resets on each death.

Adding some wording to the expression of wishes form to give some flexibility can make sense. For example:

• to explain their wishes should the spouse pre-decease them or die at the same time
• to keep the option for beneficiary's drawdown for non-dependants open
• to contact the potential beneficiaries to see if the benefit split provided is still appropriate and, if not, that a different split could be agreed.

The clearer the instructions the better, to avoid poor outcomes.

Minor beneficiaries

Where a minor is nominated as a beneficiary, it will be their legal guardian - typically a parent - who will have control of the funds, for the child’s sole use and benefit, until they have ‘legal capacity’ (age 18, or 16 in Scotland).

It may be that there are still concerns that this could be too young for someone to have access to what could be a very significant amount of money. In this case, the member may consider nominating a lump sum to a bypass trust, or a trust created in the will. 

Reviewing nominations

Nominations can normally be changed at any time  - for example, a change in family circumstances - and should be regularly reviewed to ensure that they continue to be in line with the member’s wishes and the needs of their beneficiaries, whilst providing tax efficiency.

The change in the taxation of death benefits from age 75 should be an obvious prompt to review nominations. Death benefits will no longer be paid tax free once the member has reached their 75th birthday.

Where someone has nominated a bypass trust, there will be a 45% tax charge when the lump sum is paid to the trust.  

The scheme member will need to consider if the tax charge and all that goes with it (see below) is a price worth paying for the additional control.

Control concerns? A trust can help

Clients with concerns over who will ultimately benefit, and when, may want to consider nominating a lump sum to a bypass trust for some or all of the death benefits. This can allow greater control and flexibility over how funds are eventually paid out.

This may be an attractive option, for example, where there are concerns about:

• young or vulnerable beneficiaries having access to too much, too soon
• beneficiaries with addiction issues
• children from a first marriage potentially being cut out if benefits are initially passed to a step-mother/step-father
• a beneficiary getting divorced and funds being lost to an ex-spouse

The client can specify the potential beneficiaries and appoint their own trustees to make payments in line with their wishes. 

This additional control and flexibility can come at a cost. Clients considering a bypass trust need to balance the advantages of control against the potential 45% tax charge that will apply to the lump sum paid to the bypass trust if the member dies after age 75, and the cost of ongoing trust taxation and administration. The tax deducted can be used as a credit when the trustees make distributions to a beneficiary, but it does mean that the trust only has 55% of the lump sum to invest, therefore reducing the potential for future investment growth as they’re starting with a lower investment amount.  This can be a significant disadvantage - particularly where the proceeds will be paid out over a long period.

For this reason, if a bypass trust has been nominated to receive a lump sum, it’s worth reviewing if this is still the best option when the client is nearing age 75.

Where control is a priority for the client, the trust nominated doesn’t have to be the bypass trust offered by a provider. If the provider allows it, a payment could be made, for example, to an existing trust or a trust created in the client’s will  with its own specific provisions.

This might be desired if they wish all benefits to be controlled by the same trustees under the ‘same roof’, or a trust that has been drafted principally to benefit a disabled or vulnerable beneficiary and entitled to special tax treatment.

Summary

Pension savings form a significant proportion of personal wealth for many clients, and therefore demand serious consideration when it comes to wealth transfer. Regular reviews are essential.

Ensuring that current wishes are clearly communicated to providers is a simple task and ensures that beneficiaries have all the options for taking their benefits, and the scheme trustees have the guidance to allow them to use their discretion as the client would have wanted.  

* ONS Pension wealth in Great Britain – Office for National Statistics (2020)