Many pension investors assume that the entire value of their pension fund is paid out on death, unfortunately this is not always the case. Although the recent changes brought in by the 2021 Finance Act have improved the treatment of death benefits for active members of occupational pension schemes, there is still a large disparity between the treatment of occupational and personal pensions.
If a Personal Retirement Savings Account (PRSA) or Personal Pension holder has a value of €800,000 in their pension pot when they die the entire value of the fund is paid out to their estate as a lump sum. If an occupational pension holder who has left employment or the pension scheme dies their pension fund is treated in the same fashion as a PRSA. This is also the case for a Buy Out Bond for an ex-employee.
The complications begin when a current employee who is an active member of an occupational pension scheme dies. The Revenue Pensions Manual states “Where an employee dies in service before normal retirement age (NRA) a lump sum not exceeding the greater of €6,350 or four times the deceased employee’s final remuneration may be provided.” and “A refund of the employee’s own contributions (with or without interest) may be paid in addition to any other lump sum.”
Looking at the rules in more practical terms, what does it mean for our €800,000 pension investor? Let’s call him Tom. We will assume that Tom is a member of a group scheme where the company and Tom have both being making contributions of 10% of salary since inception, furthermore we will assume that the employer provides a separate death in service of four times salary. We will assume Tom’s salary was €50,000 and that he was married at the date of his death.
When calculating the maximum lump sum payable on death we need to look at all the death benefits combined. Tom has death in service cover of four times salary, €200,000, this uses up his entire lump sum benefit. Then looking at his pension fund, as Tom and his employer have always contributed the same amount to the fund, €400,000 of the pot has been accumulated from his contributions and can also be paid out as a lump sum. That leaves €400,000 remaining in the fund that must be treated differently.
Prior to the 2021 Finance Act the only option was to use the excess €400,000 to purchase an annuity. This meant that instead of Tom’s widow receiving the remaining balance as a tax-free lump sum, they would receive a small annual income for the rest of their lives. Depending on the client’s age the annuity rate would likely be between 2% and 4% p.a. meaning that €400,000 turns into €8,000 to €16,000 p.a., which is then subject to income tax. For a widow with young children or children going to college, this could make a huge difference.
Thankfully beneficiaries now have a second option. The €400,000 can be used to purchase an Approved Retirement Fund (ARF). This means that the ARF owner will have more control over how and when they access the funds, subject to minimum drawdown requirements post age 61. Although Tom’s widow is comparatively better off in this situation compared to their position in 2021, any funds they take out of the ARF are also subject to income tax.
Having identified the problem, it is now time to turn to solutions. Unfortunately, solutions are not straightforward. The first possible solution is to transfer out of the pension scheme once the four times salary rule has become an issue, this can either be to a PRSA or an overseas pension arrangement. The client could also move to a Buy Out Bond, however the benefits may be considered as part of an active pension arrangement, if the employee has not closed all pension related benefits, so this needs to be considered. Alternatively regular salary increases to ensure that four times salary is above the level required to have the entire pension pot paid as a lump sum could be an option.
It is important for occupational pension scheme investors who have dependants to keep this rule in mind as it can significantly alter their dependents’ financial wellbeing. In our experience people that tend to be most at risk of falling foul of this rule are company owners who keep their salary low while maximising pension contributions.
Author: Eoin Hassett, Independent Trustee Company. For further information, please talk to your Financial Advisor or email firstname.lastname@example.org