A son can bear with equanimity the loss of his father, but the loss of his inheritance may drive him to despair – Niccolo Machiavelli (Italian writer 3 May 1469 to 21 June 1527)
Amongst all the potential financial complexities on divorce, the issues surrounding who might receive your money on your death may not be in the forefront of your mind. Nonetheless there are some important considerations and decisions that need to be made.
Obviously wills and LPAs (if in existence) should be reviewed post-divorce. In many cases pensions will be one of the most significant assets and consideration should be given as to who these funds should pass to on your death.
Recent changes in legislation have led to a significant shift in the way in which pension funds can be used and, due to their Inheritance Tax treatment, can often mean that they are one of the last assets that should be called on to provide an income in retirement.
“Standard” inheritance position – Expression of Wishes
Most pension schemes pay out death benefits at the discretion of the scheme trustees or administrators. In order to provide the trustees with some direction as to who should benefit, the pension member should complete an ‘Expression of Wishes’ setting out the names of those who should be considered.
In the majority of cases the member’s wishes will be followed but it is essential that the trustees maintain ultimate discretion over the payment of benefits in order to retain the tax effectiveness of the arrangements (and also ensure that benefits are paid out within 2 years of death).
Restrictions of the “Standard” position
Expression of Wishes is a simple and effective way of managing the payment of death benefits, however it is something of a blunt instrument that doesn’t always fit with the complexities of modern families. Fundamentally, the Expression of Wishes allows for the pension funds to be passed to the beneficiary who is then in control of what happens. This may or may not be what the original owner may have wanted.
For example, Mr G has a pension fund of £500,000. He is on his second marriage and has two sons from his first marriage. Mr G wishes his current wife to be able to draw an income from his pension fund, but for any residual value to pass to his sons on her death.
If he had completed an Expression of Wishes along the lines of “to my wife initially and then equally to my sons” this could result in a very different outcome to the one he intended. Following his death the pension would pass to his widow, at which point the fund would be hers to use as she thought fit. This might not give due regard to his sons. In other words their inheritance could easily be lost, whether that be by intent or simple oversight.
It’s not just complex family relationships where an Expression of Wishes can fall short of delivering the intended distribution of benefits. A higher level of control may be required where, for example:
- Receipt of a lump sum by a beneficiary may not be the best option, e.g.
- Young “spendthrift” children
- Poor mental health – drink/drug addiction
- There is uncertainty of the strength of the relationship between children (i.e. intended beneficiaries) and their partners/spouses.
- There is potential for the funds to be eroded in the event of the surviving spouse needing long term care.
Where strong control of an asset is required it is often the case that establishing a trust can provide the best solution, and this can apply to pension funds equally as well as any other assets. Largely for historic reasons this type of trust is referred to as a Spousal By-Pass trust (prior to pension rules changing in 2015, the main benefit of the trust was that it would allow the funds to be passed to the next generation without them forming part of the surviving spouse’s estate, effectively by-passing their estate for Inheritance Tax purposes).
Using a By-pass trust
As an alternative to paying the benefits directly to the beneficiaries under the Expression of Wishes, it may be possible for them to be paid into a discretionary trust (most but not all pension schemes can facilitate this).
Once in the discretionary trust the trustees can control how much is paid to whom and when. In line with the earlier example, they could provide an income to the second wife and keep the balance of the capital for distribution to the sons following her death.
Should the second wife require a capital sum (say for repairs to the house) then the trust could make a loan to her, the value of which would be retained in the trust and would create a debt on her estate.
Depending on circumstances and the value of the pension fund there may be additional tax payable under the trust route. The trust is usually a discretionary trust and therefore will be subject to periodic and exit tax charges. Specific advice should be taken here on a case by case basis to establish the tax applicable.
Following a divorce, irrespective of whether any pension share was involved, any Expressions of Wishes should be reviewed and in all probability updated.
Consider whether the client’s wishes can be fully accommodated by an Expression of Wishes. If not consider the option of a by-pass trust.
Check if the pension scheme has the discretion to pay death benefits to a discretionary trust.
Looking longer term, should circumstances change and a by-pass trust is no longer relevant, then a change will need to be made to the Expression of Wishes held by the trustees (this will not cancel the trust but will mean that no pension benefits are paid into it).
Things to look out for
At this stage I would stress that not all pension schemes offer this flexibility, however it is usually possible to move pension benefits into a scheme that does (the pros and cons of transferring pensions need careful consideration and are beyond the scope of this article).
In most circumstances, an Expression of Wishes will enable the benefits to be paid out to the correct beneficiary in a simple and tax efficient manner.
However, where the pension member wishes for a two-stage approach to the distribution of benefits, or has concerns about how the beneficiary may cope with the receipt of a lump sum then a higher level of control may be required and this can be facilitated by the use of a by-pass trust.