In this month’s article the Brand Financial Training team delves into the topic of death benefits, expecting that it will arise as an exam question or two across R04, J05, AF7 and FA2.
There is virtually nothing more certain in any of the main CII pensions exams than a question (or multiple questions) relating to death benefits.
There is a bewildering array on offer from both defined benefit and defined contributions schemes, all with different payment structures and an assortment of different tax treatments. A good working knowledge of all of these is essential for R04, J05, AF7 and FA2.
Defined Benefit Schemes – Dependent’s pensions
Let us start with defined benefit pension schemes. These can offer a dependent’s scheme pension, which is typically either 50% or two thirds of the value of the member’s pension. This can only be paid to someone legally classed as a dependent, defined by HMRC as:
- the member’s widow(er)/civil partner at the time of the member’s death;
- a child of the member who is under the age of 23 at the date of the member’s death;
- a child of the member who, in the opinion of the scheme administrator, was dependent on the member due to mental or physical impairment at the date of the member’s death;
- a person who was not married to/in a civil partnership with the member at the date of the member’s death, but who, in the opinion of the scheme administrator, was;
– financially dependent on the member, or
– in a financial relationship of mutual dependence with the member, or
– dependent on the member because of their physical or mental impairment.
The precise amounts payable and the date from which those amounts become payable are dependent on the rules of the scheme. Dependent’s pensions are not tested against any allowances, however, they are taxable as the income of the recipient, regardless of the age of the member at the date of death.
A guarantee period of up to 10 years may also be offered. The income would be taxable on the recipient regardless of age. An interesting little curveball to be aware of – If the rules allow for this guarantee to be commuted for a lump sum, the full lump sum is taxable as income unlike lump sum death benefits as detailed below which are tax free before age 75.
Defined Benefit schemes – Lump sum death benefits
Defined benefit schemes can also pay out a range of lump sum death benefits. These can be structured in a number of ways:
- lump sum return of the member’s contributions;
- multiple of salary;
- fixed lump sum;
- pension protection lump sum
Return of contributions and multiple of salary options are most commonly used when a member dies in the service of the employer.
Fixed lump sums are not common but can be offered on death at any point.
Pension protection lump sums are also less common. They are typically paid on death in retirement to help ensure that the member receives value for the pension. The way they work is that, where the member dies within a certain time of taking the benefits, such as five or ten years, the scheme will pay the pension they would have received had they lived to that point as a lump sum.
Defined benefit lump sum death benefits are typically free of tax if the member died under the age of 75 and the benefits are within the lump sum and death benefit allowance (LSDBA). This is on the proviso that the benefit is paid within two years of the date that the administrator became aware, or ought to have become aware, of the death. If the LSDBA is exceeded, then the excess portion will be taxed as the income of the recipient.
Where the member dies over the age of 75 then the benefits will be taxed as the income of the recipient.
Defined Contribution Schemes – Uncrystallised funds
Where the member dies with uncrystallised defined contribution scheme funds, there are three main options:
- Take the fund as a lump sum
- Purchase a beneficiary annuity (subject to availability)
- Designate funds to flexi-access drawdown
If the member dies before age 75, the benefit will normally be free of tax if it is paid within 2 years and under the LSDBA. Any excess is taxed as the income of the recipient After age 75 the lump sum death benefits are generally fully taxable upon the recipient.
Defined Contribution Schemes – Crystallised funds in Drawdown
The options and tax treatment available from a drawdown plan itself are similar to the options with uncrystallised funds. The beneficiary may opt to continue with the drawdown arrangement, may purchase an annuity with the funds or may take the pot as a lump sum.
Defined Contribution Schemes – Crystallised funds, annuities
Where the member has purchased an annuity then there are a further range of death benefits which may be payable, depending on the options selected at outset. Firstly, the annuity may have been set up on a joint life basis, in which case the payments will continue to the joint holder. The annuity may also have been set up with a guarantee period which ensured that it would pay for a certain number of years. In this instance the product will continue payments to the nominated beneficiary. In either of these cases, the payments will be free of tax in the event of the member’s death prior to the age of 75 and taxable as the recipient’s income post-75.
Annuities can also offer an annuity protection lump sum death benefit. This works in a similar manner to a pension protection lump sum death benefit, with the annuity guaranteed to pay out for a set period and in the event of the member’s death within that period, the balance of the outstanding payments paid as a lump sum.
Defined Contribution Schemes – Nominee and Successor Benefits
- Unlike define benefit schemes, defined contribution death benefits are also subject to the concepts of the nominee and the successor. Where benefits are paid to a legal dependent of the member then they are known as dependent’s benefits. However, there is no need for benefits to be left to a dependent and the member can opt to leave them to anybody of their choosing: Dependent’s benefits: paid to legal dependents
- Nominee’s benefits: paid to someone chosen by the member who is not a dependent
- Successor’s benefits: paid by a nominee to someone they choose after inheriting
The above represents a brief overview of what is a very in-depth and complex topic. It is also one which anybody studying for a CII pensions exam would do well to ensure they get to grips with.
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