Final salary or defined benefit schemes are considered to be the best form of pension provision due to the promise of a guaranteed income for life. For most people this may be true. However there are some circumstances in which an individual and their dependents can be better off by giving up their right to a final salary pension for a cash payment. One of these circumstances is where the member is terminally ill and not expected to live longer than 12 months.
A terminally-ill scheme member may request payment of an immediate lump sum in lieu of his or her lifetime pension. This can all be paid as a tax free lump sum. Any entitlement to a widow or dependents pension may be foregone or could still be payable, depending on individual scheme rules.
Final salary schemes are also required to offer members who have not yet taken their pension and have more than 12 months to the scheme retirement age, a cash equivalent transfer value which can be transferred to another pension scheme. Thereafter the final salary benefits are given up.
The right to transfer still remains when someone is terminally ill, in addition to the right to an ill health lump sum and ill health early retirement and all options should be considered. As the transfer value takes no account of individual longevity, it can be substantially more than the ill health lump sum which does. For some families this will be a better outcome, providing there is time to take advice before death occurs.
The advent of pension freedoms has made the transfer route an even more attractive option, especially where there are dependents who will survive the member and will be able to take advantage of the lower tax regime which applies to income withdrawn from a deceased person’s personal pension or an annuity. Providing the fund is designated to other person(s) within 2 years of the date of death there is no income tax to pay.
Income withdrawals or lump sums withdrawn in this way are tax free income in the hands of the recipients where the deceased was under age 75 at the date of death. Dependents’ income paid from the final salary scheme as a widow or widower’s pension is paid as taxable income at the recipient’s rate.
Where the transfer has taken place within 2 years of death, there may be an inheritance tax charge to pay on the fund. This is assessed on the amount by which the deceased’s estate has been reduced. If that, together with other assets of the estate, exceeds £325,000 there is a one off 40% tax charge on the excess. Outside the 2 year window this does not apply.
The transfer route can also overcome problems when the family circumstances are complex. There may be dependents who would not meet the definition as such, under the final salary scheme rules, but could benefit from the proceeds of a personal pension. The most common of these is where a couple are cohabiting but not married or in a civil partnership. Some schemes may exclude such individuals from receiving a dependents pension whereas a properly worded expression of wish form would allow the trustees of a personal pension to include them as beneficiaries.
The following real life case studies illustrate the importance of understanding all the options and taking advice on how to deal with pension benefits when the scheme member has little time to live.
Patrick was only 51 when diagnosed with terminal cancer and his doctors gave him no more than 6 months to live. He had previously worked for a firm which gave him a final salary scheme. His family circumstances were complicated as he lived with his partner with whom he had a 6 year old child but they were not married. He also had grown up children from a previous marriage and was on good terms with his ex wife, to whom he paid maintenance.
On his death, the scheme rules would have paid out a return of his contributions to the scheme as a lump sum of £20,000 but no dependents pension as the scheme only recognised a legal spouse as the dependent.
After taking advice, he requested an ill health lump sum cash payment and was offered £150,000. This would have been paid tax free to him with any sum left on death being distributed according to his will.
The transfer value offered was £600,000 to be paid into a private pension. He was able to arrange an expression of wish form which included his partner, ex spouse and children as beneficiaries. The transfer was completed 2 months before he died giving him access to the tax free cash sum to pay off his debts and the balance of the fund was left to the beneficiaries who can withdraw funds tax free from the pension plan.
John’s family were not so lucky when he too was diagnosed at 49 as terminally ill and was in a hospice. It was only when he had days to live that they sought advice on what to do about his pension.
On his death John’s scheme provided a widow’s pension of £9,000 per year to his wife for her lifetime.
A request was made on his behalf for an ill health lump sum and a transfer value. The figures offered were £310,000 plus the widow’s pension of £9,000 pa or a transfer value of £600,000. Sadly, John died before the transfer of funds to a new pension plan could be completed but at least his family got £310,000 more than they would have done without taking advice.
If a diagnosis of limited life expectation is received, taking financial and legal advice early is advisable and can make a real difference to the individual and their family.