Death benefits: Direction

What is direction?  

When a member of a pension scheme dies, the scheme administrator/trustees must pay the death benefits to someone. The process of choosing the beneficiary(ies) can either involve the scheme administrator/ trustees using their discretion, or the individual directing the choice (known as direction) before their death. The way the choice is made can affect the value of the estate for inheritance tax purposes.

Direction is where the individual explicitly directs the scheme administrator/trustees to exactly who should receive the death benefits from their plan. The scheme administrator/trustees must follow the individual's direction even if the individual’s circumstances have changed.

The value of the death benefits will normally be counted as part of the estate for inheritance tax on their death. 

It's important to note that the individual can change their mind and ask the scheme administrator/trustees to pay the pension death benefit at their discretion instead of at their direction. It is important to note that once discretion has been selected it is not possible to change back to using direction.

Direction is only available if the scheme rules allow it, very few pension providers offer it as an option.

Will inheritance tax be due when direction is chosen?  

If the scheme administrator/trustees of the pension scheme have discretion over who to pay death benefits to, the death benefits value is not normally included in the value of the deceased individual’s estate for inheritance tax. If this discretion is taken away, the death benefits value could be included. Opting for direction takes this discretion away from the scheme administrator/trustees. So as far as inheritance tax is concerned, in most circumstances, the clear winner is discretion. With discretion, the scheme administrator/trustees don’t have to abide by the individual’s wishes, so the value of the death benefits usually won’t be included in the value of the deceased’s estate and inheritance tax can be avoided on these benefits. The scheme administrator/trustees will be guided by the individual’s nominations and would have to be able to justify its decision, potentially in court.

With direction, the scheme administrator/trustees must pay the death benefits to the beneficiary(ies) nominated by the individual and in the percentages/split specified. As the individual keeps control over who receives the death benefits, they will be included in the value of their estate and so inheritance tax may be payable.

However, the value of the estate must be more than the nil rate band of £325,000 for inheritance tax to be payable. The normal spouse’s exemption will also apply if direction is used (link opens in a new window).

When would you use direction rather than discretion? 

There’s one situation where direction has an inheritance tax advantage.

If someone transfers from one pension scheme to another at a time when they know they are in serious ill-health, and the expectation is they won’t live to receive their pension benefits, HMRC may treat this as a transfer of value. This means their pension benefits may be included in the value of the estate for inheritance tax, even if they opt for discretion under the receiving scheme. Only if they survive for at least two years after the transfer will the usual treatment of discretionary death benefits apply.

Although not defined anywhere for this purpose, an individual is not likely to be classed as being in serious ill-health if they have no reason to believe they’ll die before taking their pension benefits within two years. It would likely only be treated as a transfer of value by HMRC if the individual is terminally or seriously ill at the time of transfer. 

If, under discretion, the individual does die within the two-year period due to the serious illness they had when they transferred, not only will the transfer of value be included in estate and increase the liability for inheritance tax due, but the spouse’s exemption won’t apply. This means more inheritance tax may be payable even if the death benefits are paid to the spouse. 

Somewhat bizarrely, the position reverses if direction is chosen in the receiving scheme. On death within two years of the transfer, the transfer of value will potentially be included in the value of the estate and increase any inheritance tax due, but the spouse’s exemption will apply if the benefits are paid to their spouse or civil partner. On death after two years, the spouse’s exemption will still be available but if discretion had been chosen, the value won’t be included in the value of the estate.

The Staveley case clarified and amended the circumstances in which inheritance tax on transfer applies.

Inheritance tax is likely to apply when the intention of the transfer is to confer a ‘gratuitous benefit’ to the beneficiaries. This means the individual knew they were in serious ill-health and transferred in order to get better death benefits. This will include most transfers from defined benefit to defined contribution schemes and defined contribution to defined contribution transfers where the ceding scheme didn’t provide flexible benefits and the receiving scheme does.

However, where it’s a straightforward defined contribution to defined contribution transfer where the same range of death benefit options apply in both schemes and the beneficiaries or death benefit nomination type hasn’t changed in the receiving scheme, no inheritance tax should apply even if the individual knew they were in serious ill-health before the transfer.

Find out more in our How inheritance tax might work on transfer article.

Under direction, does the scheme administrator need to pay to the beneficiary(ies) named? 

With direction, the scheme administrator/trustees have no choice – they must pay the death benefits to those named on the nomination form and the beneficiaries have to accept it even if they would rather it was paid elsewhere, for example, to a child. 

The individual therefore has total control and the benefit of certainty which may be attractive in some circumstances but at the expense of being much more vulnerable to inheritance tax.

What if the individual nominated under direction has already passed away, what happens to the death benefits? 

If the person nominated under direction has already passed away, then their share of the death benefits are paid to their estate. It cannot be paid to anyone else. 

Can direction be changed to discretion? 

If direction is selected it can be changed to discretion at any time.

However, if the individual changes to discretion at a time when they know they are in serious ill-health, HMRC will treat this as a transfer of value and so death benefits are potentially included in the value of the estate for inheritance tax. Only if they survive for at least two years after the change will the usual inheritance tax treatment of discretionary death benefits apply.

The individual can change the beneficiary(ies) at any time under both discretion and direction.

It is not possible to change from using discretion to direction unless you transfer to a new registered pension scheme. 

Should nominations be updated? 

It is essential to keep nominations up to date, especially if the individual has directed who is to receive the benefit, as circumstances can change.

Nominations should be reviewed regularly; perhaps each time you see your client or each time you carry out their regular financial review.

The individual can update their nominations at any time.