Pension death benefits – a guide to what happens to pensions upon death
Monday 12th September, 2022
What happens to my pension when I die?
The demise of the final salary pension for the majority of people in the private sector, and the large drive to auto-enrol employees into employment related money purchase pensions, has resulted in a spike in the average value being built up by individuals in their pension pots. For many, the value of their pension built up over a lifetime, may now rival the value of their house.
With so much value held in pension pots, many more people are now asking what happens to their pension when they die.
I have therefore written an article which first looks at the changes which have occurred in the pension landscape with regards to retirement options and the treatment of pensions upon death, before looking at how the state pension, final salary pensions and money purchase pensions are each treated upon death under the relatively new pension freedoms.
This is a complex area and if you have any questions, please don’t hesitate to give Atticus Financial Planning a call.
Many of us are very concerned about the accumulation of pension benefits while we are alive. We are very focussed on whether we have enough in our pensions to meet our retirement requirements. We ask ourselves:
- Is my pension properly invested?
- Am I contributing enough?
- How can I use my pension to generate an income in retirement?
- Do I have enough to retire?
All of the questions, quite reasonably, are focussed on the utility of our pension savings while we are alive.
However, with the changes brought about by the pension freedoms of 2015, there has been a new question I am hearing more and more often. “What happens to my pension when I die?”
In this article, I will briefly outline the changes to the pension environment and pension freedoms. I will then look at how the death benefits are treated for:
- State pensions
- Final Salary Pensions
- Defined Contribution Pensions
The introduction of pension freedoms and other changes
Prior to the introduction of pension freedoms in 2015, the majority of pension holders used their pension to buy an annuity. By buying an annuity, they effectively exchanged the value in their pension for an income for life. On the one hand, this offered fantastic financial security. On the other hand, there was the disadvantage that the annuity income generally died with the annuitant. At best, the annuitant could buy a spousal income, which would ensure that a portion of the annuity would continue to be paid to their spouse while the spouse was still alive. However, this would result in a lower income at the outset.
Due to particularly strict limitations on the use of drawdown, most pension members were effectively forced down the annuity route. For those who did qualify for drawdown, or did not crystallise their pension, there could be a 55% tax on pension benefits passed to beneficiaries on death.
However, in 2015, George Osborne announced the introduction of pension freedoms that would make pension drawdown (i.e. leaving your pension invested and drawing down an income from the capital as and when you wish) freely and easily available to the masses. Previously the drawdown system was very rigid for those who qualified for it. The amount you could draw out of your pension as income was limited to a percentage of the Government Actuarial Department (GAD) rates. It was complex and inflexible, and required high levels of administration and cost.
More importantly, the fixed nature of withdrawals, tied to the value of the pension and the GAD rates, meant that a pensioner relying on drawdown, could see a considerable fall in their income, should the value of their pension drop substantially during a bear market. The pension freedoms fortunately did away with all these restrictions, to the extent that a pension member could now withdraw 100% of their pension as a lump sum. With this greater flexibility and removal of restrictions, drawdown became a far more viable retirement strategy.
Furthermore, the pension freedoms did away with the punitive 55% tax on pension death benefits. This made it possible to tax efficiently leave any residual capital held in the pension at death to any person that the pension member wanted to, free from Inheritance Tax.
The impact of these freedoms was exaggerated by the very low annuity rates at the time, which meant that you would need a very large pot of money to buy a very small income. Running alongside this was the demise of the final salary pension, which meant that the responsibility for creating a retirement income was shouldered more and more by the individual, rather than the employer.
This shift of onus onto the individual to fund their retirement has been supported by the government, with the introduction of auto-enrolment of employees into money purchase pensions by their employers. People are being very forcibly encouraged to start saving into a company money purchase pension scheme from the moment that they start work, meaning that, in years to come, the average size of a retirement pot will simply increase.
For example, someone saving £100 per month into a pension from age 18 to 67 at an average return of 5% per annum, will end up with a retirement pot of approximately £238,000.
Previously, retirees were generally relying on their state pension, a final salary pension and possibly a small annuity to provide their retirement income. When I first started as an adviser, retirees were generally looking at purchasing annuities for relatively small amounts of between £30,000 - £60,000. However, the move away from final salary pensions, has meant that retirees are now quite often spending upwards of £300,000 to purchase an annuity that generates maybe £10,000 - £15,000 per year, with no inflation proofing. The point I am making is that it is painful enough to lose the annuity purchase value of £20,000 upon death. That isn’t pleasant at all. However, when you increase that annuity purchase value to £300,000, it can be positively galling.
As you can see, the old method that effectively forced retirees to use their pension to buy an annuity was no longer fit for purpose.
In reality, there was a perfect storm of conditions that changed the nature of the pension contract. Previously, it was simply a means of generating retirement income. However, the liberalisation of the pension death benefit rules and greater access to pension drawdown as a retirement option has meant that pensions are now also a vehicle for passing assets on to the next generation. In fact, many retirees are looking to use their non-pension assets to fund their retirement, while leaving their pension as an Inheritance Tax free legacy for the next generation.
As people become more and more accustomed to the fact that they will largely have to fund their own retirement, it is only natural that certain questions will arise. As average pension pots get bigger due to auto-enrolment and a greater awareness of the need to save, one of the key questions that will arise will be, “What happens to the large pot of money in my pension when I die?”
I will now look at the treatment of the different kinds of pension contracts on death.
State pension death benefits
Theoretically we save into the state pension all our working lives through National Insurance contributions. We would like to think that by the time we reach state pension age, there would be a nice pot of money built up from which our state pension will be drawn. We would also hope that any unused funds would be used to provide for our loved ones when we pass away.
Unfortunately, that is not the case. All the National Insurance contributions are paid into a National Insurance Fund, but only a proportion of this fund is used to pay the state pension. None of it is ring-fenced for individuals in the way that a money purchase pension is.
In reality, your State Pension generally stops when you die and there is no spousal stipend. In some cases, there may be the option for a spouse to increase their own State Pension based on the deceased spouse’s National Insurance record, and the surviving spouse could sometimes inherit any additional State Pension the deceased was receiving. However, with the changes in the state pension, these situations are becoming increasingly rare.
With the state pension generally dying with the recipient, this can result in a household suffering a catastrophic drop in income when a spouse or partner dies. It is therefore crucial to take account of this in any financial planning that is being done.
Final salary pension death benefits
In general, final salary pensions will make allowance for a spousal pension of between 50% and 75% of the pension income received by the retiree. They may also offer some form of ongoing payment for certain financial dependents, but this varies considerably from contract to contract. This ongoing provision for surviving spouses or dependents will generally only continue to be made to the spouse while they are still alive, or to the financial dependent until they reach a specified age. Thereafter the income simply stops.
Time and time again, I am contacted by members of final salary pensions, who find it remarkably difficult to accept that when they die, the income their spouse receives may fall 50% or more from their current entitlement. It is also difficult to accept that there will be no lump sum death benefit to pass to the next generation. This sense of loss is exacerbated by the high transfer values provided to members each year by the pension provider. For the member, it can feel like a lifetime of saving is lost at death.
However, it is important to not loose sight of the financial security that the ongoing spousal pension can still offer to the surviving spouse. The fall in the pension income due to death of the member, is generally accompanied by a fall in household costs, as there are fewer mouths to feed. Furthermore, the UK average indicates that the pension member will likely be in their eighties when they die. If this is the case, there is a good chance that the surviving spouse will also be elderly with the reduced expenses associated with greater infirmity and reduced mobility. As a result of this, the lower pension income may still be more than sufficient to meet their needs.
Furthermore, the automatic and effortless continuity of spousal pension payments, might be exactly what the surviving spouse needs in a situation where their world has been thrown into turmoil by the loss of their life-long partner. These are important considerations, when planning your retirement or contemplating taking the attractive transfer value on offer from the final salary scheme.
Defined contribution pension death benefits
These days, a growing number of people are using defined contribution pensions to provide for a sizeable proportion of their retirement income.
The death benefits available from this type of pension depends on a number of things. This includes:
- How you used your pension to provide for your retirement. In other words, did you access your pension benefits using drawdown (flexi-access drawdown, capped drawdown or Uncrystallised Fund Pension Lump Sums), or did you use the funds to purchase an annuity?
- How old you are when you die? Were you over or under age 75?
If you used your pension pot to purchase a lifetime annuity, then any death benefits will be entirely dependent on the options you selected when you bought the annuity. This can include:
- A spousal pension of anything up to 100% of the income entitlement
- A guaranteed lump sum that will be paid out to your beneficiaries upon death
- A guaranteed payment period that will ensure that the income continues to be paid from the annuity for a pre-determined period of time. This is normally 5 – 10 years, but is technically unlimited. However, most providers tend to place a cap on the guaranteed period of 30 years.
However, it is important to remember that all of these options come at a cost. Any benefits that you select will reduce the income you will receive from your annuity. At the end of the day, annuity providers are businesses aimed at making profit. This means that the prospective annuitant cannot have their cake and eat it. If you choose a lump sum to be paid by the provider to your beneficiaries, the provider will need to find a way of offering the lump sum, while still making the annuity profitable, which inevitably results in a reduction in the income they will provide. The result of this is that retirees often prefer to select no death benefit options, in order to maximise income. While this makes sense, it does mean that the annuity income and the capital used to purchase it is lost at death.
If you have used a form of drawdown to generate retirement income (or have not yet made any withdrawals), then the value of the pension pot at passing will be what is left to your beneficiaries. The beneficiary can generally choose to:
- Take money out of the pension as lump sum
- Leave the funds within the pension
- Use the funds made available to buy an annuity
The age you are when you die, plays an important role in determining the tax treatment of the pension benefits passed to the beneficiaries.
If you die before reaching age 75, the death benefits can be passed to the beneficiaries free from Inheritance Tax or income tax. However, it is important to remember that any lifetime allowance charge will still be chargeable.
Death after age of 75 will result in the benefits being taxed at the beneficiary’s marginal rate of income tax. There is unlikely to be any lifetime allowance charge, as the pension would have been fully crystallised at age 75. There will also generally be no Inheritance Tax on the assets passing to the beneficiaries. However, it is always worth taking financial advice to ensure that your pension contract is not one of the exceptions.
As you can see, like all matters involving pensions, what happens to the pension pot on your death can be quite complicated and very much depends on the type of pension and the underlying stipulations of the pension contract.
If you are concerned about what might happen to your pension on your death it is always really beneficial to speak to someone who is experienced and can provide some clarity on your situation. This will ensure that nothing is left to chance when it comes to making provision for your loved ones and ensuring that they are looked after and provided for after you are gone.
If you would like further information, please don’t hesitate to ask us for our more complete guide on pensions and retirement available upon request through our website at www.atticusfp.co.uk. There you will also find guides on:
• Inheritance Tax and Estate Planning
• Investments and tax planning
• Pensions and divorce
You can also book a free initial consultation with us, by phoning on 01420 446777 or booking an appointment via our website.