It’s been said that there are only two certainties in this world: death and taxes. Yet while death may be inevitable, avoiding its subsequent taxation has resulted in the payment of the lump sum death benefit being a potentially complex process for trustees.

Death benefits for pension scheme members fall into two categories. There are dependents’ pensions, generally for spouses/children, offered by DB schemes, and discretionary lump sum death benefits - one-off payments provided by both DB and DC schemes.

Dependents’ pensions are the more ‘straightforward’ of the two, as it is mandatory and subject to strict instructions as to who can receive the pension written in the scheme rules.

The discretionary challenge

In contrast, the lump sum death benefit can pose a challenge to trustees due to its discretionary nature.

The lump sum has to be discretionary as, according to HMRC’s Inheritance Tax Manual, “where pension scheme providers have discretion over the payment of death benefits (whether or not any letter of wishes is followed) the payment is not treated as part of the estate”, so therefore not subject to inheritance tax.

The member can fill in an expression of wish form, nominating who they would like to receive the benefit, but the trustees must demonstrate that they are exercising their discretion and not just following the form when paying out the benefit.

In the majority of cases this decision can be quite simple, with the decision as to who should receive the benefit obvious and matching the nomination form.

But as Speechly Bircham partner and head of pensions Penny Cogher says, the nomination form is not binding, but “it takes quite a brave trustee to go against the form’s wishes unless there is a good reason to do so”.

However, when these ‘good reasons’ occur it can prove a time-consuming and draining process for all concerned.

Some of the common complications that can arise include the member’s out of date expression of wish form nominating their spouse although they have since divorced or are in the process of divorcing, previously unbeknown children coming out of the woodwork, or dependent children from numerous marriages creating difficulties for trustees as to how to divide the benefit.

“The trustees don’t like it if they feel the member’s personal circumstances are quite difficult with no clear right answer where the money should go, and the nomination form is not up to date,” Cogher says.

The trustees’ personal knowledge of the deceased member’s circumstances can be beneficial in determining how much weight to put on the nomination form, although any conflicts of interest that the trustees may have must be declared.

The trustees should also speak to people that knew the member and make enquiries into possible dependents.

“You have to decide how much research is appropriate, what would be deemed appropriate if the case was put before the ombudsman,” Dalriada Trustees director Adrian Kennet says.

Once this information has been gathered, trustees have to determine the relevant and irrelevant factors.

Taylor Wessing partner Rosalind Conner gives the example where the deceased member had requested in the nomination form that the lump sum went to her partner. Her two adult children wrote to the trustees stating that the partner was abusive to their mother and them as children, and that he was an alcoholic.

“The first point isn’t actually relevant, as any old evil person can win the lottery,” she explains, “but the second can be considered relevant as the money may be squandered due to his addiction problem.” Research would have to be undertaken to prove his alcoholism instead of relying only on the daughters’ concerns, Connor adds.

Following a process

In determining who should receive the benefit, it is important that trustees establish and follow a consistent process.

“If trustees make ad hoc, inconsistent decisions in what people perceive to be similar circumstances, if they do not follow the established process, and if they do not explain their reasoning to the individuals concerned then they are asking for trouble,” Kennet explains.

As part of this process, trustees also need to be aware of the risk of holding data. Premier senior consultant John Reeve notes that as a response to data concerns, most trustees hold expression of wish forms in sealed envelopes, with any previous versions destroyed.

“However, we have had cases where, when the envelope was opened, it was found to contain general correspondence rather than the expression of wish form,” he warns.

According to Reeve, trustees need to consider how to keep hold of these forms. Electronic scanning may be one option, but “questions of confidentiality need to be carefully considered”.

Trustees are allowed to keep the data as long as they use it for its specific reason, Cogher says, but once it has been used for that purpose it should be destroyed. The holding of data has yet to cause problems, she adds, as members recognise that they need to give the data in order to receive the benefit.

Determining who should receive the lump sum can take a long time to decide. However, it should be determined within two years; otherwise it would be classed as an ‘unauthorised payment’ and become subject to 55 per cent tax.

Even though two years sounds like ample time, Connor notes that one dispute she dealt with “took so long to argue over that one of the two potential beneficiaries died”.

To speed up the process, it is recommended that trustees set up sub-committees to deal with these payouts.

If by the end of this complaints are made, they tend to be about trustees not taking all considerations into account, or blindly following the expression of wish form instead of first researching all options.

Mandatory or discretionary?

To avoid this time and complexity, Connor recommends that the tax treatment for the lump sum be changed.

“No one really likes (the discretionary element of the lump sum payment) as trustees have to spend ages looking into the member’s situation, even though they often follow the member’s request, and the member doesn’t get that certainty,” Connor explains.

Her solution would be to change the current rules so trustees can automatically pay the lump sum to who the member nominated or their next of kin without it being subject to inheritance tax.

“By far the easiest thing to do is to say that we don’t need this benefit to be a discretion, we just need it to get the tax breaks as if it was one, and then the member can direct who can get the money and that would just make everyone’s lives massively easier,” she adds.

While removing the discretionary element of the lump sum will solve a number of challenges for trustees, it can be a blessing and a curse.

The dependents’ pension element is not discretionary, and as Kennet explains: “If the rules require you to pay it to the spouse, even though the member was separated, then you pay it to the spouse. It may not be what the member wanted but the trustees are constrained by the rules.”

This constraint can cause problems for unmarried couples in public sector schemes TPAS chief executive Michelle Cracknell adds.

“We occasionally see some unfortunate cases where a scheme member has died and their partner has been denied a dependents’ pension,” she explains. “This is because a signed nomination form needs to be held on file if a dependents’ pension is to be paid. In the last case I had the scheme (civil service) hold a form for the lump sum benefit but not for a dependents’ pension. The couple had clearly been in a relationship for a long time but the scheme had no discretion to pay anything.”

Cogher states that the discretionary element of the lump sum can have a beneficial role for the member, as whom they nominate to receive the benefit can differ from their estate.

“People could do something that the family member may not hear much about, so if they wanted to keep something secret this might be a way of doing it. They could make the trustees’ life easier by adding a letter explaining this with their nomination form,” she explains.

Nomination forms

So both discretionary and mandatory benefits have pros and cons. What would help immeasurably however, for both dependents’ pensions and the lump sum, is an up-to-date nomination form.

Some schemes AHC technical consultant Karen Partridge has worked with only had nomination forms for 10 per cent of its members, “so there is clearly a desire to increase that to make trustees’ job less difficult”.

Including a nomination form within all communications and providing an incentive to return it can help a great deal, she adds. Some schemes also send reminders whenever it becomes aware of a change in circumstance, such as a change of address.

According to Partridge, it is quite a complicated process to explain to members the trustees’ discretion for tax purposes, but that members “should fill in the form even though it may not be abided by”.

Move to DC

Even though the message is complex, members may be more willing to listen as DC savings increase.

Punter Southall Independent Trustees principal Gillian Graham notes that as more people save in DC schemes, dependents’ pensions are being replaced with lump sums that have a higher multiple of salary insured.

These higher lump sums, along with the Budget announcements enabling people to take their pension pot as a lump sum, could make members more likely to keep their nomination form current.

“These changes are making pension money more ‘real’ for the member, so I wonder if this will result in people becoming more diligent about making their wishes heard?”, Partridge muses.

Members way well take more of an interest in their death benefits as their pension pots become more tangible. Only time will tell. But until then, along with death and taxes, death benefits creating challenges for trustees seem another certainty.

Laura Blows is editor, Pensions Age

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