How to pass on your pension safely
In the old days, there was very little to be done with your pension. It came with work, and was designed to provide you with a regular income through the few years between carriage clock presentation and your wake in the Dog and Duck.
If you died while you were still working, your spouse (widow, typically) received a lump sum; otherwise, you were paid a fixed income when you retired, and on your death the spouse would continue to receive a half or two-thirds dependant's pension to see her through. When she died, that was the end of your pension fund. There was little flexibility; there were no decisions to be made.
Final salary schemes still operate along those lines, but they are a dying breed. For other types of pension fund the rules changed in April 2011 to make it easier to pass on your pension fund capital, not just a continuing income for dependants.
The changes affect self-invested personal pensions, most other modern personal pensions and group personal pensions. In theory they also affect all occupational money purchase schemes. However, says Michael Robey, pensions commentator at the government-backed pension scheme Nest, this will depend on individual scheme rules, so it's important to check with your own scheme.
"Some may still have rules that require a member to take benefits at age 75, or which provide a default pension if no active decision is made by that date. Those schemes that have amended their rules to take advantage of the tax simplification may have rules around how death benefits will be paid after age 75, and which options are available to the beneficiaries," he explains.
So what do the new rules say? Unused pension funds have always been inheritable to some extent. But until 2011, inheritability ended either when the pension fund was "crystallised" (used to provide an income), or once you reached the age of 75, whichever happened first. The view was that pensions were there to provide income for the elderly; they were certainly not to be viewed as a savings pot that could benefit the next generation.
"Thus, before the rule changes, if you hadn't touched your pension fund when you got to 75, you had either to buy an annuity with it at that point, or take an Alternatively Secured Pension (ASP), a form of drawdown, under which the death benefits were taxed at 82%," explains David Downey, technical pensions manager at Standard Life. "That was very unattractive, so almost no companies offered ASPs and an annuity was really the only option."
The 2011 changes relaxed the tax laws requiring benefits to be secured by age 75. As a consequence, if you haven't annuitised unused pension pots at age 75, or if you use income drawdown instead of taking a scheme pension or buying an annuity, it's now possible to pass on your remaining pension wealth on your death.
If you die before the age of 75 with an untouched pension, the entire value of the fund can be paid out, free of tax up to the lifetime allowance (£1.5 million). If you're over 75, then it will be taxed at 55% before any payout takes place.
"However, given that your estate will lose 55% of the fund to tax anyway if you die aged 75 or over and it is still unused, it's sensible to crystallise it once you reach 75. That way, you can at least take 25% tax-free. You can then go into income drawdown or buy an annuity with the rest," says Paul Garwood, head of financial planning at accountant Smith & Williamson.
If you buy an annuity, you may want to insure the risk that you may die before you've received much annuity income; Garwood suggests making use of a value protection policy.
On your death this will pay out the value of the fund less those income payments already made. That sum will then be taxed at 55% before passing to the estate.
Crystallised pension funds
When you reach a stage where you need to draw on your pension fund, you have two basic options. You can use it to buy an annuity that will provide a continuing income for the rest of your life; if you choose a joint life annuity then, should you die before your spouse, he or she will continue to receive an income. But on the second death the annuity "dies" too.
"If security of income for you and your partner is the most important consideration, and for many people it is, then an annuity is the right choice," says Garwood. "But if pension inheritability is a consideration, this isn't a good option."
The alternative is to go into income drawdown, leaving the fund invested and drawing an income directly from it. As a result of the rule changes, whether you die before or after age 75, the remaining pension fund can be inherited after deduction of 55% tax.
"A dependant beneficiary - for example a widow - can choose to take the fund as income, either continuing to receive drawdown payments or buying an annuity," says Colin Lawson, managing partner at Equilibrium Asset Management. "There is no tax charge in that case, other than income tax at the recipient's marginal rate." However, he adds, only dependants can opt for the income route.
Death benefit options
The pension scheme administrator's default position, in the absence of other instructions, will be simply to pay it to your estate. If the payment is made from an uncrystallised fund and 40% inheritance tax (IHT) is already a potential issue, it's preferable not to have what could be a substantial pension fund added to it. However, if a payment is made to your estate from a crystallised drawdown fund, there is no further IHT to pay on top of the 55% tax charge.
So what can you do to ensure that any remaining pension fund ends up where you want it on your death?
One option is to set up a trust before you die and arrange for the proceeds to be paid into that. The trustees can then transfer money to beneficiaries as and when they see fit, which means they can retain control of the funds to minimise potential tax liabilities, or in the face of complex family circumstances such as a child's divorce and remarriage. But this option is not available under occupational schemes or some personal pensions that are already under a trust, so you will have to check your plan.
In any event, Garwood observes, not everyone needs that level of flexibility. "The pension scheme itself is either in the form of a trust or a similar structure, so in the absence of more concrete instructions the administrators will have some discretion over whom they transfer the lump sum to," he says.
A common practice is therefore for scheme members to make a nomination by giving an "expression of wishes' to the administrators in writing, asking them to consider paying the fund to specific beneficiaries in given proportions when the time comes.
"The administrators don't have to follow this request - but they usually do,' says Garwood. "However, if there is a surviving spouse but others - the children, for instance - have been nominated in preference, they will check that the spouse is otherwise catered for before making any distributions."
A final option is to do nothing (as many people do through inaction), in which case the payments will be made at the scheme administrators' discretion. As already mentioned, they may simply write a cheque to the estate and be done with it, potentially causing or increasing an IHT liability if the scheme is uncrystallised. But Garwood says it's quite likely in practice that they will liaise with your executors and agree beneficiaries on your behalf.
To be sure that your own preferences are followed, however, the obvious solution is to make your preferences known via your will and an expression of wishes to the pension scheme.
It's clear that people who can afford to consider the possibility of passing on some pension wealth would like to do so. Recent research by Standard Life among its customers showed that 95% of respondents are keen to control what happens to their pension inheritance. But uncertainty and apathy continue to hold sway. Almost half of respondents have not completed an expression of wishes, and more than half don't know whether their will controls how their pension is passed on.
There is clearly a need for better education about pension inheritability. Wealthier individuals who have IHT concerns and those who use financial advisers are more likely to be up to speed with the options - but anyone with a pension fund could be affected if they die before it has been crystallised.
Given that your pension is probably the largest or second-largest asset you own, it's well worth deciding what you'd like to happen to the cash if you're not around to use it.
What can you do to pass on your pension?
Look at the terms of your pension to establish how far you can take advantage of the new rules.
A popular option is to make a nomination to the pension scheme administrators, to ensure the money goes where you would like it to go.
If you have not made an "expression of wishes", ensure your will includes details of how you would like your pension fund to be distributed.
Where the spouse is well provided for and could themselves face a potential IHT liability, Lawson suggests using a spousal bypass trust. This means the money remains outside the spouse's estate but they and other beneficiaries are still able to benefit. It's mainly used for uncrystallised, pre age-75 funds, where there is no 55% tax, but it can be used for drawdown funds as well.
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.