The scheme of things

Most people will invest in a number of pension schemes throughout their working lives. For personal representatives (PRs), this can be a time-consuming and difficult challenge when dealing with an estate administration. This article is a back-to-basics guide for PRs, explaining their responsibilities, the practical steps to take, and the tax consequences to be aware of.

Where to start

The first step is to establish how many pensions the late member saved into throughout their life. How straightforward this task is will depend on what records they kept.

Pensions in payment can be easily traced from a bank account, but take care – some may be payable infrequently (for example, annually). Pensions not in payment can be much harder to find without well-filed statements, although if the late member had a financial adviser, they can help you.

The late member may also have had other pension savings, possibly linked to an old employer and therefore not immediately visible. You can use the Pension Tracing Service, and the Unclaimed Assets Register may also help.

What information will I need?

The next step is to gather all of the essential information from the pension scheme administrator to carry out your responsibilities as a PR. These include identifying:

• the value of each pension at death
• for each pension, if benefits have been accessed (known as “crystallised”) and, if so, the amount of lifetime allowance (LA) used at the time
• whether any pension had received a “transfer in” within the last two years
• details of any contributions made within the last two years
• details of any “nomination” (sometimes called an “expression of wish”)
• full details of any death in service benefit, to establish if it was written under pensions legislation.

Thankfully, all pension providers must provide PRs with the information they require, so no special authority is required. This will give you a solid foundation to carry out your role.

Was the lifetime allowance exceeded?

A core responsibility as a PR is to work out whether the late member accumulated pension benefits over their LA. If so, you must notify HM Revenue & Customs (HMRC) and the beneficiaries.

Death benefits are tested against the late member’s LA when they are paid from uncrystallised funds on death before age 75. The LA, currently £1,073,100 for 2020/21, is the maximum tax-efficient fund that an individual can build up without having to pay a tax charge – known as the lifetime allowance excess charge.

Each time the late member accessed their pension funds, a “crystallisation event” took place that used a percentage of their LA. The pension scheme administrator will be able to provide an accurate account of the percentage used during each event. These percentages will need to be added together to establish how much, if any, of the LA remains for any benefits which need to be tested on death, such as an “uncrystallised” pension plan that has not yet been accessed, or death in service benefits from an employer’s scheme.

It is important to check whether the late member had any form of LA protection that may afford a greater level of protection, and if they did, that this remains valid. Certain actions taken during the late member’s lifetime, such as making pension contributions after the registration date, may void some protections.

If you think the late member would have been eligible for LA protection, you can make a posthumous application that could save the beneficiaries substantial amounts in tax.

If there is a tax charge, you will ordinarily need to provide HMRC with the following information within 13 months of the death, or within 30 days of becoming aware of the chargeable amount:

• the name of the pension scheme that paid the death benefits
• the scheme administrator’s name and address
• the late member’s name and National Insurance number
• the amount(s) and date(s) of payments under each pension
• the chargeable amount.

Once notified, HMRC will obtain details of the beneficiary / beneficiaries from each pension scheme and contact each of them directly to arrange payment of the tax.

The pension provider will pay the full amount of the fund directly to the beneficiary(ies), who is (or are) personally responsible for making payment of any tax due to HMRC on the excess amount of the fund. The amount of tax will depend on how the money is received.

As a key role for a PR, determining which pension benefits need to be taken into account when administering the estate and assessing the LA position can be complex. Taking expert independent financial advice can save time and cost and, crucially, ensure the correct calculation is made.

Planning opportunities

If benefits are not paid within two years of notification of death, no LA charge applies, and the funds will be subject to tax at the recipient’s normal rate of income tax. If the member passed away before they reached age 75, would delaying distribution to some or all of the beneficiaries achieve a better net outcome?

In addition, a charity lump sum death benefit does not trigger an LA test, so it could be worth considering this for excess benefits.

When pension assets may be included in the estate

While pension plans do not normally form part of a late member’s estate, there are a number of occasions to be aware of when pension assets can be included and are subject to inheritance tax (IHT).

Direction of death benefits

The process of establishing who the beneficiary(ies) is (or are) can either involve the pension administrator using its discretion, or the late member having directed it through a binding nomination. Importantly, where a pension is included in the late member’s will, this is not binding on the pension administrator.

If the pension administrator does not retain discretion in terms of who the death benefit is paid to, the pension will be included within the estate.

If direction is given, the pension administrator must pay death benefits to those named, who must also accept it, even if they would prefer for it to be paid to somebody else. Some older pensions may only offer a direction as an option to members, so it is important to find this out.

Transfer of value

Pensions may be included in the estate if the late member passed away, due to ill health, within two years of making one or more of the following changes:

• pension transfers from one scheme to another
• unusually large pension contributions
• assigning benefits into trust.

Under these circumstances, HMRC may argue that there has been a transfer of value.

The loss to the transferor’s estate will be added to the estate for the purposes of IHT, although this is a grey area. HMRC’s IHT manual gives little guidance and there is little case law: HMRC v Staveley [2017] UKUT 0004 (TCC) is a good starting point. This protracted case has highlighted the complexity and confusion surrounding pensions and IHT. The case is currently being reviewed by the Supreme Court to provide greater clarity on the rules.

On the topic of contributions, this also includes those paid to somebody else’s pension, although in this situation, for the purposes of IHT, these payments would be either exempt, under the annual exemption, or the gifts-out-of-regular-income rules, or potentially exempt.

You will be asked these questions on the probate application forms, so it is important to have this information to hand.

In the absence of any evidence to the contrary, if the late member survived two years from making the changes outlined earlier, HMRC will usually deem that the actions were carried out while they were in good health.

Payments that form part of the estate

A number of payments can also form part of the estate:

1. arrears of annuity payments to the member on death
2. a deferred state pension paid as a lump sum to the estate
3. payments under a guaranteed period paid to the estate or at the late member’s direction, until the fixed period comes to an end (HMRC has a useful calculator to ascertain the open market value of this right: take care here, as this only works for “standard” annuities)
4. a value protection lump sum paid to the estate or at the late member’s direction (the value net of tax would be included).

For points 3 and 4, if the continuing payments are made at the discretion of the annuity provider, they are free of IHT.

Pensions where the estate has a legal entitlement to the value

A number of older-style pensions, particularly retirement annuity contracts (known as RAC or a “section 226”, from the Income and Corporation Taxes Act 1970) and buyout policies (known as deferred annuity plans or a “section 32”, from the Finance Act 1981), will form part of the estate unless placed in trust during the late member’s lifetime.

Omission to act

This was a historical issue as part of pensions administration, but recent legislation (schedule 16(47) to the Finance Act 2011) has resolved this.

The omission to take retirement benefits while in ill health (the two-year rule, described above) is no longer considered to have been a transfer of value (see Fryer & others v HMRC [2010] UKFTT 87 (TC)).

Determining the beneficiaries

In most instances, pension benefits fall outside a person’s estate, so are not covered by a will.

For defined benefit (DB) pensions, the scheme rules will determine who is eligible to receive death benefits. Defined contribution (DC) pension trustees are guided by a “nomination” made by the member during their lifetime. They could nominate one or more of the following:

• an individual
• a trust (commonly known as a spousal bypass trust)
• a charity (if there are no dependents).

A copy of each nomination can be obtained directly from the pension administrator or the financial adviser (if applicable).

The vast majority of nomination forms are not binding, so pension administrators retain discretion and can consider payments to other individuals. In our experience, most pension administrators follow the member’s wishes from the nomination form, unless there is a strong argument not to.

All potential beneficiaries must be named explicitly, rather than as a class of beneficiary. This is a crucial distinction between pensions and trust-related estate planning 

Problems often arise because the nomination is a number of years old, and the individual’s circumstances changed after the nomination was made. For example, if someone nominates their spouse, then divorces them and does not update their nomination, the pension administrator may be obliged to respect their original wishes. We encourage all clients to ensure nominations for all pensions are completed, and updated where necessary to reflect changing family circumstances, such as divorce or a birth.

As a PR, you may often discover that the late member never actually got around to making a nomination. In this instance, the pension administrator will gather evidence from the family, look to the will and consider the overall circumstances to determine who should benefit.

You should contact the pension administrator as early as possible if you feel that there are other people who should be considered as beneficiaries.

Planning pointers

All potential beneficiaries must be named explicitly, rather than as a class of beneficiary. This is a crucial distinction between pensions and trust-related estate planning.

With discretion, the pension scheme provider can consider other beneficiaries or change the allocation of funds between beneficiaries.

During the late member’s lifetime, if they nominate a small percentage, such as 0.01%, to all potential beneficiaries, this will maximise the death benefit options available to each of them. Only those who have sought specialist pension advice are likely to have taken this valuable course of action.

Beneficiary options

This will depend on the pension type.

State pension

If there is a surviving spouse or civil partner, they will not receive the late member’s full state pension. Their own entitlement (or their entitlement when they reach state pension age) may increase though, so it is worth checking with the Pension Service. Their entitlement is lost if they remarry or enter into a new civil partnership before they reach state pension age.

It is possible that the late member deferred their state pension. If so, and there is no surviving spouse or civil partner, as PRs you can claim up to three months’ pension. This would form part of the late member’s estate.

Annuities

The death benefit provisions available depend on whether the late member chose these when purchasing the annuity. One or more of the following three death benefit options may have been included:

1. a guarantee period, with the annuity continuing to be paid for a set period of, say, five or 10 years
2. a joint life basis, whereby the surviving spouse or civil partner continues to receive a percentage of the pension (usually following the end of any guarantee period, although it may overlap, so it is worth checking this)
3. capital or value protection, whereby a lump sum will be paid net of the annuity payments received by the member.

If no death benefit provisions were selected, the annuity will simply cease, with no further benefit.

Payments to beneficiaries are tax-free if the late member died before the age of 75, and will be taxed at the beneficiary’s normal income tax rate if they died aged 75 or over.

Defined benefit pensions

DB schemes are often referred to as final salary schemes or career average earnings schemes. The death benefits available depend on whether the late member was in receipt of their pension, an active member of the scheme, or a deferred member.

• In receipt of pension: the scheme will usually continue to pay a reduced pension, typically 50%, to a bereaved spouse or civil partner and/or a dependent’s pension. These will be taxable at their normal rate of income tax.
• Active member: a lump sum as a multiple of the late member’s salary is often paid, as well as a return of the member’s own contributions. These will generally be tax-free, given the member will most likely have been aged 75 or younger when they died. A pension may also be payable to a bereaved spouse or civil partner, or other dependent, and if so, would be taxable at their normal rate of income tax.
• A deferred member (who was no longer contributing to the scheme and had not yet taken benefits): the death benefit option may only be a return of the member’s own contributions, albeit these would be free of tax. Schemes that are more generous will include a pension for the bereaved spouse or civil partner, or other dependent, which would be taxable at their normal rate of income tax.

Each scheme will have its own rules dictating the death benefits available, along with specific and far stricter definitions (relative to DC pensions) for a dependent, so obtaining a copy of the rules will be useful.

While death benefits are restricted, PRs can play a key role in helping to identify and ensure all dependents, including those who may not be immediately obvious, receive what they are entitled to.

Defined contribution pensions

Most modern workplace and personal pensions, including self-invested personal pensions, fall into this category. DC pensions are the focus of many planning opportunities.

The “pension freedoms” introduced in 2015 included sweeping changes to the way in which DC pensions can be passed to beneficiaries, and their subsequent tax treatment.

Under current legislation, a DC pension can be passed on to any beneficiary of the member’s choice, and not just limited to a spouse, civil partner or dependent. It is also possible to have a mixture of death benefits, and for these to be provided to more than one beneficiary, depending on what is best for each of them.

While legislation allows it, not all DC pension schemes have adopted the new freedoms, so you will still need to check with each provider to understand the options.

Under the new freedoms, beneficiaries have four options:

• payment of a lump sum
• purchase of a lifetime annuity
• flexi-access drawdown
• the scheme pension.

The most suitable option depends on each individual beneficiary’s specific circumstances and financial position. This is another area where independent financial advice is crucial in ensuring the beneficiaries achieve the best outcome.

The beneficiaries will receive the death benefits free of tax, as long as the following three conditions are met:

1. the late member died before the age of 75
2. the late member had sufficient LA remaining
3. payment of the funds is made by the pension administrator within two years of death.

If the late member was aged 75 or older, the benefits will be taxable at the beneficiaries’ normal rate of income tax, when accessed.

While the death benefits for state pensions, annuities and DB pensions are effectively dictated to the beneficiary, the control and flexibility in DC pensions can offer significant planning opportunities.

A DC pension is a long-term investment. The fund value may fluctuate and can go down. A beneficiary’s income will depend on the size of the fund, future interest rates and future changes to tax legislation.

Conclusion

This article covers many options and potential issues when handling pensions in an estate administration, but it is not exhaustive. This is a complex area, with numerous eventualities. With so many different types of pension in existence, each with their own rules, along with complex LA and IHT issues, PRs must be confident they have taken all necessary steps.

For more information, see The Private Office’s Pensions Specialists page.