There was a lot of noise in advance of the autumn budget around pensions, with suggestions that employer pension contributions might be caught by national insurance and that the tax free lump sum on retirement might be affected.  While this did not come to pass, there was a significant change around death benefits from ‘registered’ pension schemes.

While stability generally is to be welcomed, as some of the speculated changes had the potential to undermine the real progress made by auto enrolment in encouraging pension saving, the change to death benefits has serious implications for employers, trustees and members.

There will be a consultation on the detail of implementation, but it seems unlikely the idea will be dropped. At this stage we recommend member communications now in use should be reviewed and updated to avoid any risk of future claims that misleading information continued to be published.

Death benefits – what’s changing?

Changes to the tax regime earlier in 2024, in particular the removal of the lifetime allowance, created the scope for creative tax planning for some high net worth individuals.  Undrawn pension savings, without any limit on amount, could in effect be passed on to beneficiaries without any inheritance tax (IHT) charge. That issue primarily applies in personal pensions and DC workplace schemes. The intention to tackle it was trailed before the Budget.

The principle is easy to grasp but it is far from clear how it can be extended to workplace pension schemes, particularly defined benefit schemes. Broadly, from April 2027, most lump sum death benefits from pension schemes will be treated as part of the deceased’s estate and so come within the scope of inheritance tax.  According to the Office for Budget Responsibility (OBR) report, this is expected to raise £1.5bn by 2029–30 (although the numbers are very uncertain, as to date pensions have normally not been included in the data held on death estates).

The long-standing position that death benefit lump sums payable on discretionary trusts are outside IHT is to be abolished. How this will actually work in practice remains unclear and subject to consultation, but this means that where any death in service lump sum, contribution refund on death in deferment, or 5 year guarantee lump sum on death after retirement (or while postponing retirement) is payable, it will potentially be caught by IHT.

Benefits for dependants have always been a valuable part of benefit design – and while lump sums paid to a legal spouse or civil partner will remain outside of the IHT regime, other dependants may find a material impact on what they expected to receive.

When it comes to survivor pensions, the wording of the consultation document is confusing about “unused pensions” and “discretionary pensions”. It seems that dependants’ pensions payable from a scheme are not intended to be caught, whether payable as of right now or as a result of a discretion.  They will simply continue to be subject to income tax as paid in the normal way.

Benefits under “life policies” are to be exempt. What this means in relation to individual or bulk annuities will need to be clarified.

What does it mean for trustees?

For trustees, death benefit discretions have often been a difficult area; balancing potential tax consequences as an additional factor in what can be complicated and emotionally charged circumstances in their decision making will be an unwelcome complication.  They will also have to consider how best to communicate the change to members, given that most member communications will have stated that lump sum death benefits were “currently” tax free.

The change will also raise some very challenging practical issues.  Trustees will it appears be legally liable to pay the IHT charge within six months of a member’s death, but will be reliant on others (personal representatives, once they are identified and are willing to act) to notify them of the death, and request and provide the necessary information, before trustees determine (where relevant) who is to receive benefits and in what form and then adjust for IHT – against a background (often) of grieving survivors in desperate need of immediate benefits.  Trustees will be very reliant on responsive administrators with time on their hands if they are to avoid maladministration complaints.

The number of estates where IHT is charged has been around 4%. Even if this goes up significantly, will administrators be faced with additional obstacles and delay in the 90% of cases where IHT won’t be payable?

The Government is consulting on the processes required to implement these changes over the next couple of months.  A lot needs to be clearer and for a significant overhaul to systems, April 2027 is not that long away. Employers and trustees should start thinking about how to accommodate this sooner rather than later.

What does it mean for employers?

Employers may wish to consider whether providing lump sum death benefits for employees through alternative mechanisms outside the pension scheme, such as group life policies, may be more attractive if not already doing so. As the change does not apply until deaths in 2027, there should be time to consider and implement a change which doesn’t affect the agreed benefit itself.

Inevitably, the changes to NI thresholds raise the prospect of possible changes to auto enrolment thresholds when next reviewed (the last was February 2024) so employers should be aware there may be more to come as a tail end from this budget.