Death benefits for defined benefit schemes
What types of death benefits can be paid from defined benefit schemes?
Find out about the types of death benefits that can be paid from a defined benefit scheme and how they’re taxed.
Defined benefit scheme death benefits – what do you need to know?
- Defined benefit schemes usually offer lump sum death benefits and scheme pension.
The lump sum death benefit will usually be a set amount or a multiple of salary.
Lump sum death benefits are tax-free if the member dies under age 75, the lump sum is within the member’s lifetime allowance and it is paid within two years of the scheme administrator becoming aware of death.
Scheme pension is usually based on a percentage of the member’s pension entitlement.
Scheme pension is taxable regardless of the member's age when they die.
Who can be a ‘dependant’?
There have been a few recent high profile court cases so changes may be on the way but currently, occupational pension scheme rules will detail what benefits are payable and who would be classed as dependants or beneficiaries. The benefits provided may include a lump sum death benefit and / or dependant’s scheme pension.
HMRC’s definition of a "dependant" is broadly:
- the member's widow(er) or civil partner at the time of the member's death
- a child of the member who is under the age 23
- a child of the member who, in the opinion of the scheme administrator, is dependant on the member, because of physical or mental impairment, at the date of the member's death
- a person who wasn't married or in a civil partnership and is not a child of the member, who in the opinion of the scheme administrator is, at the date of the member’s death:
- financially dependent on the member
- in a financial relationship of mutual dependency with the member; or
- dependant on the member due to mental or physical impairment.
Pension scheme rules may restrict to a narrower definition of dependant (for example, a younger cessation age for a child's pension). The extended meaning of ‘dependant’ for a child of the member who reaches age 23 on or after 16 September 2016 applying to defined contribution schemes doesn’t apply in respect of dependant’s scheme pensions. So, if the child is not a dependant because of physical or mental impairment, the pension must cease by age 23.
Certain factors are important when considering death benefits. Whether the member died before or after 75, if the death happened pre or post crystallisation and how the benefits are to be paid. Achieving age 75 is classed as a crystallisation event (although the member may not have actually crystallised the pension) - as such post age 75 all death benefits (crystallised or uncrystallised) are treated as post-crystallisation.
Defined benefit lump sum death benefits (DBLSDB)
This is a lump sum which is paid from a defined benefit arrangement. There is no limit on the level of defined benefits lump sum death benefit that can be paid from a defined benefits scheme. DBLSDB is usually only payable on death before retirement. The amount paid may be:
- a set amount promised by the scheme,
- linked to the member's salary at the time of death or
- based on some other measure, but
- cannot be based on the amount of funds available to provide the benefit (if that was the case then this is not a defined benefit lump sum death benefit).
Since 6 April 2016, there are no time limits on the payment of a DBLSDB. However, if the member dies under 75 and it is paid outside the two-year period, there are taxation implications which are discussed below.
A lump sum can’t be a DBLSDB if it meets the conditions for a:
pension protection lump sum death benefit
trivial commutation lump sum death benefit
winding-up lump sum death benefit.
Paragraph 13 Schedule 29 Finance Act 2004
The lump sum will be specified by the scheme rules. This can be provided directly from the scheme (where the scheme self-insured the cover) or may be insured through an assurance arrangement. HMRC don't limit the sum that can be paid on death. Generally, the scheme will set an amount of lump sum payable if a member dies before taking retirement benefit (usually expressed as a multiple of salary, for example, four times salary).
A term-assurance policy that pays out a benefit on the death of the member by reference to the individual's salary is providing a defined benefit. However a policy that pays out a set monetary amount is providing a cash balance benefit and as such cannot be classed as a defined benefit lump sum death benefit and is likely to be paid as an uncrystallised funds lump sum death benefit.
A lump sum payable under a five-year guarantee can be treated as a DBLSDB as long as it meets the conditions of being paid from a DB scheme and being based on a defined calculation rather than based on the amount of funds available. The member must also have not asked for the guarantee to be paid as a pension protection lump sum death benefit.
It’s not uncommon for schemes to use this approach as an alternative to commuting five-year guarantee periods, which ceased to be allowable from 6 April 2006 (A-Day).
HMRC give the following examples of lump sums payable on death that would qualify as a defined benefits lump sum death benefit:
- a multiple of earnings, such as 2 x final salary (eg group life assurance payable on death in service), or
- a multiple of service eg £500 for each year of service with the employer, or
- a multiple of another factor eg 3 x prospective pension or 10% of the employer's profits in the accounting period before the member's death, or
- a lump sum of a fixed amount of benefit eg £100,000 even if provided by a life cover policy NB read note below.
However, a fixed amount of £100,000 paid out on death but not expressed in benefit terms and might be paid as either a pension or a lump sum (ie where the form of benefit is to be decided on or after death), is not a defined benefit LSDB but a cash balance benefit.
The lifetime allowance and taxation of DBLSDB
The lifetime allowance
A DBLSDB, for death pre-crystallisation and before age 75 (that is, benefits not previously tested), paid within the 2 year window, triggers a lifetime allowance test. This is BCE 7 – where a relevant lump sum death benefit is paid on the death of the member. Before age 75, the amount paid, or crystallising, is the amount tested against the deceased member's lifetime allowance. Any part of the payment outside of the lifetime allowance is a chargeable amount and taxed at 55%, due on the recipient of the payment.
HMRC Pensions Tax Manual - PTM 088680
Personal representatives are responsible for identifying whether a chargeable amount has arisen following the payment of a relevant lump sum death benefit. They only need to do this after the payment of any death benefits which are tested against the deceased's lifetime allowance.
The provider may pay the lump sum death benefits in full, without regard to any lifetime allowance charge that may potentially be due. Where the personal representatives identify a chargeable amount, they must report this to HMRC, who then assess the recipient of any payment that may give rise to a chargeable amount (55% of the lump sum). Therefore, the personal representatives must be provided with the percentage of the standard, or protected, lifetime allowance used up by a relevant lump sum death benefit within three months of the payment. The personal representatives may also request the percentage of the standard, or protected, lifetime allowance that the member had crystallised to date, ie to enable them to calculate any charge due. This must be provided within two months of their request.
HMRC Pensions Tax Manual - PTM165000
If the member was 75 or over when they died then the DBLSDB is not tested against the LTA. There will have been a BCE 5 when they reached age 75. If the payment is outside of the two-year period and the member was under 75, the DBLSDB is not tested against the LTA but it is taxable as discussed below.
If BCE 7 (a relevant lump sum death benefit) is the first BCE triggered after A-Day, then any pre A-Day pension in payment must be included when calculating the percentage of lifetime allowance already used up. The calculation is 25 x the pension in payment at the date of death.
If the pre A-day pension in payment is a capped drawdown plan, then there is a further step to consider. You can read full details for this in our Lifetime Allowance: The Facts article.
HMRC Pensions Tax Manual - PTM088300
Post 6 April 2016, if the member was under 75 when they died and the DBLSDB is paid within the two-year period then it is tax-free.
Death benefits paid where the member dies after age 75, or paid outside of the two-year period where the member died under age 75, are taxable in the hands of the recipient. If the recipient is an individual then the DBLSDB will be treated as the recipient’s pension income and tax will be deducted under PAYE.
NB where the recipient’s tax code is unknown, the payment will be taxed using emergency (month 1) rules and the recipient will need to contact HMRC to either reclaim any overpaid amount or arrange further payment if more tax is due.
If the payment is to a non-individual then the special lump sum death benefit charge of 45% applies.
Where the non-individual is the estate, there is no tax credit and none of the 45% special lump sum death benefit tax charge is reclaimable.
Where the non-individual is a trust and depending on the type of trust, the trustees may be able to pass on a tax credit when making payments from the trust to the beneficiaries.
Where the non-individual is a bare trustee, the special lump sum death benefit tax charge won’t apply and the lump sum payment to the trust is taxed as though it is being paid to the ultimate beneficiary (PAYE applies).
Section 206 Finance Act 2004
Section 579A, 636A,636AA Income Tax (Earnings and Pensions Act) 2003
A spouse's guaranteed minimum pension (GMP) can’t be commuted for a DBLSDB – it must be paid either as a pension, or as a trivial commutation LSDB. However, the calculation of the DBLSDB can include the value of the member's GMP. For example, the member's pension at the date of death was £1000 per month, including £200 pm GMP. There is a DBLSDB payable, which is calculated as 5 x the member's pension at date of death. The calculation of the DBLSDB can include the value of the member's GMP as long as the scheme still meets its obligation of paying the spouse the spouse’s GMP.
A dependant’s scheme pension may be provided under both a money purchase arrangement and a defined benefits arrangement. However, it is more likely to be paid under a DB scheme as defined benefit schemes can only offer scheme pension. If the member wants to access different options at crystallisation, they’ll have to transfer their benefits to another type of scheme. However, unfunded public sector pension schemes cannot be transferred to provide flexible benefits.
Scheme pension may be paid either by the scheme administrator of the registered pension scheme providing the pension or, if the scheme’s liability to pay the pension has been secured through the purchase of an annuity contract, by the insurance company underwriting that contract.
A dependant’s scheme pension:
- does not have to be paid for the life of the dependant, it may be stopped at any time in accordance with the rules of the scheme or the terms of the annuity contract,
- does not have to be paid annually,
- may be reduced at any time in accordance with the rules of the scheme or the terms of the annuity contract,
- can’t be guaranteed for a certain term or have pension protection, pension commencement lump sum, or provide a benefit to someone else on the death of the dependant.
Dependant’s scheme pension may be in the form of:
- pension for spouse, partner, or civil partner; and / or
- children's pension (normally paid to a certain age, longer only in the case of a physically or mentally impaired child).
If there are no dependants (as defined by the scheme rules and/or HMRC rules), a lump sum (in addition to any DBLSDB, detailed above) may be payable. A dependant’s scheme pension does not need to come into payment immediately following the death of the member and if there are multiple dependants the payments can technically start at different times. It may be deferred as there are continuing guaranteed pension payments, or because the dependant is still young. Again full details of whether this is allowed will be set out in the scheme rules.
Scheme pension pre-crystallisation
On the member's death before crystallisation, any dependant's pension from a defined benefit scheme will usually be based on one of the following:
- a percentage of the member's pension entitlement at the date of death
- a percentage of the member's pension entitlement assuming they had worked until the normal retirement age of the scheme
- a percentage of the member's pension entitlement based on somewhere between the above figures. For example it's common for public sector schemes to add a fixed number of years of service to the member's pension entitlement at the date of death.
Scheme pension post-crystallisation
In the event of death after crystallisation, the scheme documentation will confirm what benefits are payable. The benefits provided are generally:
- continuation of the member's pension for a "guaranteed period" (usually so that the member's pension is paid for a minimum of five years, which would mean no continuation if the pension started more than five years before death) and thereafter,
- dependants' pensions, usually as a percentage of the member's pension, in the form of:
- pension for the spouse or civil partner,
- children's pensions (if provided – and few schemes do provide children's pension – paid to a certain age, or longer if dependency continues, as in the case of a physically or mentally impaired child).
If the capital value of the dependant's benefits is under £30,000, under trivial commutation lump sum death benefits rules, the benefits can be paid as a lump sum. The whole amount of any trivial commutation lump sum death benefit is taxable in the hands of the recipient.
Paragraphs 15(2B) and 16 Schedule 28 Finance Act 2004
Lifetime allowance and taxation of scheme pension
There is no lifetime allowance test when a dependant becomes entitled to scheme pension, regardless if this derives from previously crystallised pension rights or uncrystallised pension benefits. None of the deceased member's or dependant’s lifetime allowance is used up.
Where a dependant's pension is paid through a scheme pension, the dependant receiving the dependant's pension will be liable to income tax on the continuing pension payment, at their own rate of tax. This is in contrast to annuities and drawdown taxation where death benefit payments are tax-free on death before the age of 75 (pre or post-crystallisation). However, this treatment doesn't apply to scheme pensions.
Where instalments continue under a guaranteed period, it's the recipient(s) [the person(s) who get the payments in accordance with the member's will / the laws of intestacy] who'll be liable to income tax on the ongoing instalments, again at their own rate(s) of tax.
Where a dependant's pension is paid to the estate, prior to it being distributed to the beneficiaries under the deceased's will / the laws of intestacy, tax is deducted at the personal representatives' rate of tax (basic rate). When the dependant's pension is subsequently paid to the beneficiary, it will be classed as "basic rate of tax paid" and will only be liable to further income tax if the beneficiary is a higher or additional rate tax-payer.
If a guaranteed period / short-term continuation of the member's pension is specified, any outstanding instalments that become payable on the death of the member form part of the member's estate for IHT purposes. This means that the value of those instalments is potentially liable to IHT.
If they're paid to the member's surviving spouse / civil partner or financial dependant, no IHT will actually be payable as these transfers are exempt from IHT. Where the instalments aren't paid to a surviving spouse / civil partner, these will be liable to IHT (assuming the overall value of the annuitant's estate is greater than the available "nil rate band" at the time of death).
Dependant's scheme pension limit
The amount of dependant's scheme pension is limited in certain circumstances:
- if the member dies on or after age 75, and
- if the member dies after 5 April 2006, and
- a scheme pension was being paid at the member's date of death, or he or she was prospectively entitled to one.
If these conditions are met, generally the aggregate dependant's scheme pension payable to any dependants of the member must not exceed 100% of the member's scheme pension payable at the date he or she died.
The calculation of the initial member pension limit is prescribed, but is broadly equal to 100% of the pension paid to the member in the 12 months preceding his date of death, plus 5% of any pension commencement lump sum paid. If the member has not been in receipt of a pension for more than 12 months, the dependant's scheme pension is the amount he would have received in the first 12 months.
The subsequent increases that can be granted to a dependant's scheme pension that has been limited are also limited.
Different limits may apply to small pension schemes, under 50 members etc.
For full details see HMRC Pensions Tax Manual PTM072120
Where the member's scheme pension was in payment on 5 April 2006 and the member dies subsequent to that date, but before reaching age 75, the limit on the dependant’s scheme pension does not apply.
The Taxation of Pension Schemes (Transitional Provisions) Order 2006/572
Transfer of dependant's scheme pension after benefit crystallisation event
Regulations provide for the transfer of sums / assets by registered pension schemes and insurance companies, where those sums / assets represent pensions in payment. A transfer of sums / assets from a dependant's scheme pension between registered pension schemes is only treated as being a recognised transfer if those sums or assets are applied for the provision of a new dependant's scheme pension. Where the dependant's scheme pension is being paid by an insurance company, the amount transferred is treated as an unauthorised payment if a new dependant's scheme pension is not provided.
The Registered Pension Schemes (Transfer of Sums and Assets) Regulations 2006
From 6 April 2012 protected rights ceased to exist, so the death benefits payable have no special restrictions that used to exist. A schemes rules / documentation could however have restrictions depending on how their rules are framed.
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