In December 2022, the Institute for Fiscal Studies (IFS) reported that defined contribution personal pension funds are increasingly being left untouched during retirement and instead being used as tax-free inheritance vehicles. This was stated to be partly due to the fact the death benefits payable to pension-holders who die under the age of 75 are ordinarily free from income tax. In addition, pension funds are normally inheritance tax exempt on death if the scheme is written under trust and the trustee has discretion on who to pay the benefits to.
In their report, the IFS has highlighted the need for reform, making two key recommendations for a tax system which is fairer and more efficient from an economic perspective:
- Firstly, regardless of the pension-holder's age at death, levying basic-rate income tax on all funds that remain in pensions at death.
- Secondly, including pension pots in the value of estates at death for inheritance tax purposes.
The tax benefits for defined contribution personal pensions mean that they are a particularly good savings vehicle for leaving money to family and dependants. What therefore would the implications of these reforms be for pension-holders who do die under their retirement age and wish to leave behind funds for dependents? Some in the pensions industry have commented that these changes may become a hindrance to people trying to provide for their family, or indeed they may incentivise pension-holders to take their tax-free cash lump sum earlier than perhaps they would ordinarily. In this article, we consider the alternative option of group life assurance that employers can (and indeed already do) provide employees in respect of death benefits and their tax treatment.
What is Group Life Assurance?
Group Life Assurance (GLA) is a benefit that an employer can provide to a group of employees, which offers death-in-service benefits. Essentially, GLAs offer trust-based life assurance over enabling employers to provide a tax-free lump sum benefit for an employee's family and dependants (which can include nominated beneficiaries specifically singled out by the employee), on the death of the employee. This lump sum will either be a fixed amount, or a multiple of the relevant employee's salary. A discretionary trust is used to separate out the cash benefit from the deceased's estate, which allows them to be paid without being subject to inheritance tax.
Employers who provide GLA usually do this through a registered pension scheme, i.e. a scheme which is registered with HMRC (a Registered GLA). However, some chose to use an excepted GLA, which is not registered with HMRC (an Unregistered GLA). Whether a GLA is Registered or Unregistered, the benefits they offer are usually insured with providers. There are providers who offer employers access to master trust structures, whereby employers are able to delegate administration and responsibility (for example, as to which beneficiary to pay the death benefit to), for a fee.
Registered GLAs: what and why?
A Registered GLA will be subject to usual pension scheme tax rules, meaning that any lump sum benefit paid in the event of a death claim contributes to the relevant employee's lifetime allowance (the maximum amount you can draw from a pension in your lifetime without paying extra tax). There are no inheritance tax charges which apply, and Registered GLAs can be more flexible offering different levels of cover within the same policy, however the benefits payable must remain within a limit set by HMRC and conform to a range of statutory restrictions.
Registered GLAs offer employers tax relief on premiums they pay towards the scheme.
Unregistered GLAs: what and why?
As mentioned, a Registered GLA is subject to usual pension scheme tax rules and therefore where an employee is likely to have met their lifetime allowance, they may wish to opt for an Unregistered GLA to avoid having to pay extra tax on any death benefits payable over the limit. However, it is important to bear in mind that the policies under Unregistered GLAs must not be taken out where the main purpose or one of the main purposes is to avoid tax, as specifically referred to in the relevant tax legislation. Employers must therefore take care in deciding which employees are eligible and what the purpose of the trust is. However, we note that in practice many employers do offer both Registered and Unregistered GLAs.
Unregistered GLAs are governed by life insurance legislation rather than pension legislation, and therefore the benefit does not form part of the lifetime allowance. For this reason, Unregistered GLAs can be particularly attractive to high-earners or individuals who have built up larger pension pots.
Unregistered GLAs are set up through a discretionary trust (with the employer also acting as trustee, like with Registered GLAs), which means that they are subject to the usual inheritance tax rules. This means that in certain circumstances, they can be more risky for employers from an inheritance tax perspective, as they can give rise to:
- entry charges: a charge arising out of something of value being placed in the trust;
- periodic charges: a charge arising at each 10 year anniversary of the trust on any thing of value in the trust; and
- exit charges: a charge arising out of something of value leaving the trust.
The only asset permitted in an Unregistered GLA is the policy itself (which needs to comply with various requirements), which is unlikely to be deemed to have any value if all members are of good health on the date the policy was settled into the trust. However, where a member is terminally ill or where a member has died close to the 10 year anniversary and death benefits are due, these policies will be deemed to have a value on which tax charges can apply.
As the trustees have discretion over the payment of the death benefits, they are not treated as being within the relevant member's estate, the inheritance tax charge is due by the employer sponsoring the scheme as trustee.
Registered or Unregistered?
For employers, the key to deciding which scheme to offer is to consider which employees will be covered. Where the employees are less likely to hit their lifetime allowance, Registered GLAs can provide employers with flexible options and the ability to claim tax relief on premiums. However, where employers do need to consider higher earners, Unregistered GLAs can be considered. Carefully drafted, Unregistered GLA trusts can help to mitigate the risk of inheritance tax charges, by ensuring that the trust expires ahead of the ten year periodic charge and manages the entry and exit of policies.
