Feature

posted 24 Jun 2005 in Volume 10 Issue 4

Assessing A-day: The impact of 6 April 2006 on death benefits

John Dunseath, an associate at Whitehall Financial Independent, provides an overview of death benefits available from pensions from 6 April 2006, otherwise known as A-day.

Benefits on death before vesting

Death benefits in the new regime are generally more generous than those available at present. On death before retirement it will be possible to pay out:

Amounts up to the member’s available lifetime allowance (£1.5m initially) as a tax-free lump sum;
An unlimited amount of dependants’ pensions.

Any pensions already crystallised will have reduced the availability of the lifetime allowance.

For money purchase schemes, the £1.5m limit includes both the value of funds built up for the purpose of pension savings, which are paid out as a lump sum on death, and any additional lump sum provided by life assurance under a pension scheme.

It is possible to pay unrestricted lump-sum benefits in excess of the value of the lifetime allowance, but any excess above the allowance will be taxed at 55 per cent. The liability to the lifetime allowance charge is on the recipient of the lump sum.

Dependants’ pensions are not tested against the deceased’s lifetime allowance, and will be treated as income in the hands of the recipient – for example, spouse and/or children – and taxed accordingly. Nor do death benefits pay in the form of a dependant’s pension count towards the lifetime allowance – they are, therefore, unlimited.

There is no change to the inheritance-tax treatment of death benefits. As now, benefits paid at the trustees’ or administrators’ discretion, are normally free of any liability to inheritance tax.

Death benefits after vesting

Lump-sum death benefits payable directly to an individual will not be permitted after age 75, regardless of whether these are paid directly by the scheme or indirectly under some other arrangement. The only exception to this is where an occupational-scheme pension came into payment before A-Day with a five-year guarantee that could be commuted on death. However, there will be the options of the transfer lump sum and charity lump-sum death benefits described below.

Lump-sum death benefits will be allowed from vested funds before age 75. These can take two forms:

Death benefits from unsecured funds – in other words, income drawdown. Here, a full return of fund is permitted in much the same way as at present, subject to a tax charge of 35 per cent. This is a welcome change from the original proposals, which based the return on death on the amount initially invested in drawdown, less the income taken;
Death benefits from secured funds – in other words, annuities or a scheme pension. Here the lump-sum death benefit is based on the Inland Revenue’s original ‘value protection’ proposals. The maximum return on death will be limited to the amount crystallised, less any instalments of income received up to the date of death. Like the lump-sum death benefit from income drawdown, any amount paid out under value protection will be taxed at 35 per cent.

Pension schemes may also offer a guarantee period of up to ten years on pension payments. It will be possible to buy an annuity with a ten-year guarantee from funds that have been used for unsecured income (drawdown), though the guarantee must end ten years after the benefits are originally vested (date when drawdown starts).

Death after age 75

After age 75, no lump-sum death benefits are permitted from lifetime annuities and scheme pensions. Guarantee periods can, however, theoretically continue up until the day before the annuitant’s 85th birthday.

It will also be possible to continue drawing benefits after age 75 from a fund in much the same way as income drawdown. This method is known as ‘alternatively secured pension’.

On death while in alternatively secured pension, any remaining fund must first be used to provide an income for a spouse and/or other dependants. If a spouse/dependant is over age 75 this can be annuity purchase, scheme pension or continuing alternatively secured pension; if under age 75 this can be annuity purchase, scheme pension or unsecured income. A residual fund may arise if there is no spouse or dependants at the date of death. In this case, the residual is dealt with in one of two ways:

Distributed among one or more members of the pension scheme nominated by the member or, if the member made no nomination, selected by the scheme administrator. This is to be known as a transfer lump-sum death benefit;
Paid to a charity nominated by the member before his or her death. This is to be known as a charity lump-sum death benefit.

Dependants’ pensions

Dependants’ pensions can be paid to spouses and minor children and anyone else who in the opinion of the administrator was dependent on the member at the time of death. These can continue for life, for all adult dependants, or may cease on re-marriage. A dependant’s pension paid to a child must cease at age 23, though pre A-Day pensions can continue until the end of full-time education. A child can still be classed as a dependant after age 23 for other reasons, for example, disability. Someone who was a spouse of the member when the member first started to receive their pension can still be classed as a dependant if they are divorced from the member at the time of the member’s death.

There is no limit on dependants’ pensions apart from a dependants’ scheme pension, which cannot exceed the member’s. Dependants’ pensions cannot have an income guarantee or value protection.

Passing on a residual pension fund to the next generation

The new tax regime also creates an opportunity to pass on un-drawn pension funds to future generations of your family after age 75 via the transfer lump-sum death benefit. Under alternatively secured pension (similar to income drawdown but income limited to 70 per cent of the maximum single-life pension at age 75), no minimum income is required.

If no income is withdrawn, the fund will remain largely intact. On death, any residual fund must firstly be used to provide spouse’s and/or other dependants’ pensions. However, where the scheme member has been pre-deceased by their spouse (or they are divorced) and their children are over the dependency age of 23, the residue can fall to the scheme.

If that scheme is set up with other family member’s non-dependent children or grandchildren, for example, the residue can be used to augment the pension savings of those other family members.

The scheme itself is likely to be similar in construction to a small self-administered scheme. However, an employer contribution is no longer needed to establish such an occupational pension scheme (this was a requirement of the Chapter I tax rules, which will be swept away as part of these reforms).

So a scheme can be established without a sponsoring employer, meaning that this planning opportunity will be open to all – not just those families where all scheme members are employed by the same business.

The government have always resisted attempts to use pensions for ‘estate planning’ and they have recently taken a step towards clarifying the position with pensions and IHT avoidance in the form of a written Ministerial Statement from the Paymaster General, the Rt. Hon Dawn Primarily. In the statement, the Treasury’s overall approach to IHT avoidance is outlined pretty well and we are told that there will be more consultation soon on this aspect of the new pension laws.

An extract from her statement says: “We have been asked to clarify how inheritance tax (IHT) will apply to choices made by pension scheme members under the new simplified pension regime, and, in particular, what the implications are when scheme members opt for an alternative secured pension rather than taking an annuity at age 75 as they have been obliged to do in the past.

“The same broad principles will continue to apply to the new regime as they have done to the old rules, and as they do to any other situation where people are able to make choices affecting their future wealth and that of others.

“People are broadly treated as making a taxable transfer for IHT purposes when they omit to increase their own wealth in favour of increased wealth for others, just as they are when they transfer to others wealth that they already have. This is a principle of general application, and has always applied to choices under pension schemes as it has to any other choices that people make about their wealth. It is important that we maintain this principle, both in the interests of fairness between taxpayers and to ensure that pension funds remain dedicated primarily to providing retirement income.

“I have asked the Revenue to open discussions with interested parties to seek a consensus on the detailed application of IHT law to the new situations arising under the simplified regime, and on how, in practice, cases which are chargeable should be identified and any charge should be quantified. The Revenue will shortly be publishing a consultation document setting out their analysis of the IHT issues as a basis for these discussions.

“ASPs were designed to provide an alternative to annihilation for those with religious objections to risk pooling. They were not meant as a vehicle for inter-generational transfers by scheme members generally, and the government will continue to monitor the situation to ensure that they are not being used for avoidance.”

An alternative solution: The Open Annuity

The Open Annuity is a product provided by London and Colonial Assurance PLC, a Gibraltar based insurance company. Robin Ellison, the chairman of Open Annuities Ltd (the UK holding company of London & Colonial Assurance PLC) designed the product in consultation with the Inland Revenue. He has been elected as the next chairman of the National Association of Pension Funds (NAPF). The NAPF is the leading trade body for the major occupational pension funds.

At inception, the Open Annuity policyholder buys, with funds outside their pension monies, a £1,000 preference share in the Open Annuity insurer. Each annuitant has a segregated account, which is established using their net (after any tax-free cash has been paid) pension-fund monies.

Like any other annuity, the annuitant receives periodic payments until death in return for their lump-sum payment to the Open Annuity insurer. The payment chosen must fall between the prescribed minimum and maximum amount for that year. The fund can be invested in an extensive range of collective investments with no restriction on choice of fund manager.

The preference share has no value until the Open Annuity ends, at which point it will equate to the amount remaining in the annuitant’s own segregated account.

The preference share cannot be placed in trust, assigned or sold. On the death of the annuitant (or their spouse if a joint life annuity has been selected), the annuity contract ends and any funds remaining in the account become ‘mortality profit’ for the insurer. At this point the preference share falls into the deceased’s estate. The administrators or executors will then approach the Open Annuity insurer to exchange the preference share for the mortality profit from the annuitant’s segregated account. This payment would include the original share subscription price of £1,000 and the interest earned on it while in the account.

So the key distinction of the Open Annuity is that on death (at whatever age this occurs), the full residual value of the segregated account is transferred to the annuitant’s estate. If the annuitant was a UK resident, inheritance tax would apply to the estate. However if the annuitant is survived by a UK domiciled spouse then the payment would be exempt.

The Open Annuity will no longer be available in its current format from 6 April 2006, when pension legislation changes. The product is not suitable for everyone due to the fairly high charges and the £250,000 minimum-entry level. It is particularly suited to individuals with sizeable pension funds wanting to pass funds to spouses and/or children after death; to individuals approaching age 75; to individuals with spouses considerably younger than themselves; and to those in ill health.

John Dunseath is an associate at Whitehall Financial Independent Ltd. He can be contacted at johnd@wfiltd.co.uk