Reading the small print on treatment of death benefits

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Sam and David have been friends all their lives. They live next door to each other, work at the same company and socialise together. They are both married and each have two young children.

Looking to the future, they are keen to make sure that, in the event of their deaths, their respective wives would have access to the funds they would need and that any remaining money is then passed on to their children at the appropriate time.

Although Sam and David have the same pension arrangements, they have different financial advisers. Offering the fullest range of financial flexibility for their loved ones in the event of their deaths is identified as their main priority.

Nominations

Sam and David are both advised to fill out their expression of wishes form for their pension schemes.

Sam’s adviser has read a lot about the “98+1+1” method of pension nominations. After speaking to Sam he decides this would be a suitable method to achieve his goal of passing on the death benefits to his wife and children.

The rationale for choosing the “98+1+1” method is that, under the pension freedom legislation, it should offer the scheme trustees the fullest range of options for the spouse and children who have been named on the expression of wish form.

In a scheme that offers full discretion, this method would offer the trustees the ability to vary the amounts they decide the nominees should receive, as well as offering income and lump sum payment options.

However, David’s adviser is aware that, while pension freedom has expanded the options available from a legislative perspective, ultimately when it comes to how the pension fund is distributed following a member’s death, it is the individual pension scheme rules that count.

After speaking to David about his wishes, his adviser contacts the scheme to determine how nominations in his particular one would be treated. His adviser finds the scheme has a binding nomination on dependants, which would include spouses and children under 23, named in an expression of wish form. This means the trustees do not have flexibility over how the death benefits are distributed and must give them as per the expression of wish form or the scheme rules, if the beneficiaries are dependants.

David’s adviser drafts an expression of wish form to state that, in the event of David’s death, he would like the trustees to contact his wife to ascertain if she feels she would require some of the money from the scheme, and whatever is left should pass directly to the children.

Tragically, while out fishing six months later, Sam and David both drown when their boat sinks. Following their funerals, their pension schemes are informed of their deaths and the process of distributing the death benefits begins.

Entitlements

As the nomination is binding for dependants on Sam and David’s pension scheme, the scheme trustees will have to pay Sam’s wife 98 per cent of the benefits and 1 per cent to each of the children.

If his wife tries to give up her entitlement to pass the benefits to the children, the payment to the children would be classed as an unauthorised payment and would be subject to punitive tax charges. It is unlikely the scheme would allow this and would therefore offer the 98 per cent to Sam’s wife as either dependant’s drawdown or a lump sum.

As David’s adviser had previously checked with the scheme about how death benefits would treated, it makes contact with David’s wife. She advises them of how much she feels she needs to maintain her standard of living and the remainder of the fund is passed directly David’s children. As a result, his wife only requires 50 per cent of the pension and the remaining 50 per cent is split between the children, which is placed into dependant’s drawdown for them.

Pension freedoms have introduced a degree of legislative scope for passing on death benefits to loved ones and through the generations. But it is vitally important to check the individual pension scheme rules regarding how death benefits are treated, as it is these that count. There is no compulsion on pension schemes to incorporate the changes introduced under pension freedoms. Without checking what the scheme can offer, the right outcome cannot be guaranteed.

Mark Devlin is technical manager at Prudential