How do death benefits get paid?

Members of a defined benefit scheme (also known as final salary) will be subject to their pension scheme rules, so the pension is usually only paid to a dependant of the person who died, usually a spouse or civil partner or a child under the age of 23.

When it comes to defined contribution pension schemes, sometimes called money purchase schemes, there are three things that can be done with a pension upon death: it can be paid as a lump sum; the beneficiary can take over the pension and withdraw as much or as little as they want (drawdown); or they can buy an annuity.

Pension assets typically sit outside of a person’s estate, but this does not mean the pension transfer is free of tax necessarily. 

Scheme rules

Another key point people need to understand is that, although the law allows for family members to inherit a pension, it is not every pension scheme that allows for this flexibility.

Les Cameron, head of technical at Prudential UK, says: “Pensions schemes will have their own rules about what they allow. So you have to be careful if you are intending to pass your pension wealth by allowing somebody to inherit your pension.

“You need to make sure the scheme you are in actually allows the death benefit flexibility that pension freedoms opened the door to, as many schemes don’t. You’ll be forced to buy an annuity, which might not be popular, or forced to take a lump sum. 

“Broadly speaking, money should not leave the pension system unless you have a need to spend it. So it is really crucial you make sure the pension scheme you are in has the death benefit arrangement that allows the full flexibility.”

Under a DC pension, most plans will operate a simple expression of wish, which is a non-binding expression to the trustees that the settlor wishes for the funds in their trust-based pension to be passed to that stated individual. 

Due to the structure of the trust-based pension, the benefits are held outside of the estate. 

Pensions schemes will have their own rules about what they allow. So you have to be careful if you are intending to pass your pension wealth by allowing somebody to inherit your pension.--Les Cameron

Death claim process

The death claim process involves firstly informing the provider of the death of the scheme member, at which point the provider will determine if there’s been a lifetime allowance excess, explains Jason Barefoot, IFA at Ascot Lloyd.

Assuming there has not been, the trustees will then seek information from the executors to establish who should benefit from the pension, normally asking for a will or the member’s family information, and then will align this information to that outlined on the expression of wish.

Once they themselves elect to agree with the expression of wish, the provider will send an official confirmation to the beneficiary outlining their options for the amount elected to them. This will either be given as a cash sum direct to the bank or a nominee drawdown arrangement – effectively a continuation of the pension in the beneficiary’s name.

If the pension scheme member passed away before they turned 75, and this process completes within two years, regardless of the option selected, the funds will be paid tax-free, though if the member passed after age 75 then the funds will be subject to income tax at the beneficiary’s rate.

Although pension death benefits are ordinarily inheritance-tax-free, an exception to the rule are contract-based pensions, specifically those that are known as retirement annuity contracts or section 32 pension buyout 'bonds', which would ordinarily form part of an individual's estate.

Some DC plans will not be held in trust and will therefore be included within the estate, so it’s crucial for each member to determine the exact structure of these.--Jason Barefoot

These policies are created by a contract through the individual and the insurance company, as opposed to most other pensions which are trust based or use a similar structure, says Alistair Cunningham, financial planning director at Wingate Financial Planning.

A trust-based pension ordinarily has discretion to whom benefits can be paid and while it is possible to complete the expression of wish giving a non-binding guide to where the money should go, most wordings will make it clear that there is no binding direction on the city administrator and therefore it is not subject to IHT.

It is also possible to pass a lump sum death benefit to a separate trust in most cases. Importantly, tax is likely to be paid on the lump sum generated if it is invested outside of a tax-efficient vehicle like an Isa.

Barefoot says: “Some DC plans will not be held in trust and will therefore be included within the estate, so it’s crucial for each member to determine the exact structure of these. 

“Additionally, some providers will not provide an option for the beneficiary to continue in a drawdown arrangement, which can be hugely detrimental to the beneficiary."

Cunningham adds: “It's important to note, just because the legislation allows both options (lump sum and drawdown) many older-style pensions have not been updated to the post-2015 rules and may only offer a lump sum, meaning that if an individual dies with older-style pension, the recipient may be forced to have a lump sum even if they don't desire it.”

When it comes to DB schemes, it is dependant on the scheme rules of the member’s pension scheme.

The scheme rules will state if a spouse pension or dependant’s pension is available if the member passes away, and at what rate this would be paid.

Barefoot adds: "For example, a recent plan I saw indicated that in the event of the member’s death, the scheme will pay 50 per cent of the member’s pension to their spouse for the remaining amount of their life.

"Another point to note is that the scheme rules may be different if the member passed before the retirement age. I’ve seen some that would merely provide a return of the member’s pension contributions, without interest. In short, the member’s individual scheme rules govern it all.”

The member would have completed a nomination within their pension to say who their dependent is, to ensure the scheme can simply alter the income accordingly.

Cameron says: "One of the key things about being able to inherit someone’s pension is, you have to be nominated. [As the person passing on the pension], you have to make sure your expressions of wish have been updated, otherwise if you have only updated your spouse and not your children, your children would be forced to take a lump sum. 

"If you want your children to inherit your pension and have the ability to stay in drawdown, make sure you have nominated them to stay in your scheme. Nobody wants to think about dying, but the more organised you are for your death, the easier it will be for your next generation."

Ima Jackson-Obot is deputy features editor of FTAdviser