Passing on your pension when you die
When you retire, you usually give up your retirement savings in return for a monthly pension income. Your children won't inherit a penny of your hard-earned cash. Here are some solutions.
This article concerns lovemoney.com readers who have a group or personal pension. It does not concern those whose employers pay them final-salary pensions.
You save up and invest for retirement and then from your savings pot you usually get a monthly income, called an annuity.
If you die before you cash in your pension for an annuity, you’re often entitled to a lump-sum payment to your spouse or beneficiaries.
But if you die after you have bought an annuity, the company that paid you the annuity usually keeps all your money - even if you had hundreds of thousands in your pension pot and died just one year after you bought the annuity.
In my opinion, that’s not much return for your hard work over the decades.
However, it’s possible to buy an annuity that will continue to pay your spouse when you die. You can choose whether he or she will receive your full annuity, two-thirds of it, or half. By opting for your spouse to continue to be paid on your death you’ll receive a slightly lower monthly annuity income, but your spouse will have security – and you will have peace of mind.
When your spouse dies, however, the payments will usually stop. And whatever is remaining in your pension pot will remain with the annuity provider. If you want your pension to go to your children or anyone else, you'll have a much harder time of it.
I’m going to consider now some of your options and alternatives.
Buy a guaranteed annuity
You can buy a special type of annuity with a guaranteed term of five or ten years. If you die within that period, this type of annuity will continue to be paid in full. It may be that you’ve opted for your spouse to receive half your annuity on your death already. However, with the guarantee, he or she will receive the full annuity during this guaranteed period.
The guarantee is probably more useful for your children though. If you are single, or if both you and your spouse die during the guaranteed period, your children can also receive the annuity for the duration of the guaranteed period.
Get the 25% tax-free lump sum
You can usually take 25% of your retirement savings as a tax-free lump sum when you retire. This is normally worth doing for everyone, as it makes your money more versatile. You could still, if you chose, buy an annuity with it, or you could invest it. More importantly for this article is that you could spend some of it now on your dependants. If you give gifts to your children and then survive seven years, the gift will be exempt from inheritance tax, too.
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Alternatives to regular annuities
So far I’ve been talking about the rules for ‘regular’ annuities. The reason regular annuities are so popular is there is relatively little risk to your financial security for the rest of your life, provided that the income you receive from your annuity is high enough to combat inflation till you die. You get a guaranteed monthly payment regardless of how long you live. Thus its wide appeal.
All other income solutions for retired people require you to keep investing your money. Your investments need to grow to fight inflation, but at the same time you’re eating into that same pot in order to live. If your investments crash you could be in trouble. Therefore, alternative solutions to regular annuities are not to be taken lightly, particularly by inexperienced investors.
The most common alternatives to consider are:
Unsecured pensions (for under 75s)
Your pot remains invested, so for many people there is considerable risk. However, you can choose to take more or less income each month, within certain limits. Therefore you can take more money from your pot and give it to your heirs. If you do this regularly from excess pension income, it probably won’t be subject to inheritance tax either.
You could pass on the majority of your pension pot, using this method, between the ages of 65 and 75. However, if you’re going to run down your pension pot in this way, you’ll need to be rich enough to live without it.
Alternatively secured pensions (for over 75s)
When you turn 75, the Government will not allow you continue to have an unsecured pension. You’ll either have to get a ‘regular’ annuity at this point, or get an alternatively secured pension (ASP).
With ASPs, you continue to invest your pension pot, so it’s at risk. The plus side is that – unlike an annuity - you can pass on your pot to whomever you wish when you die.
However - and this is a big one - when you die (and your spouse if you’re married) your beneficiaries will face great taxes on any lump sums paid to them from the remaining pot. They’re likely to face 70% in various taxes and punitive charges.
If the estate is large enough, there may also be inheritance tax, which boosts the total taken by Revenue & Customs to 82%, leaving just 18% for your heirs. If the remaining pot is too small, some providers would refuse, under their terms and conditions, to pay out what’s left.
Not good alternatives
So these two alternatives to regular annuities, particularly the ASP, suit relatively few people, and usually just the well off.
As you can see, it’s not easy. If you want to pass on some of your retirement savings to your heirs then you should consider investing more in ISAs and less in pensions.
I’ve covered just a few possibilities, but this is an area with great scope for ingenuity and cunning. If you have any ideas, please post them below.
You may also wish to take professional advice if you're considering buying an annuity in the near future. But you can also get help from the lovemoney.com community if you have a specific question on your finances in retirement. All you need to do is try out our excellent Q&A tool.
This is a classic lovemoney.com article which has been updated for 2010.