Neil Jones: Piloting your pension to the good life

Following the pension freedoms, many believe that pilot trusts, also known as bypass trusts, are redundant, but that isn’t necessarily so, writes Neil Jones

For many years it has been possible to pass on a pension fund to a spouse, civil partner or dependant and since 2015, with the introduction of nominees, successors and beneficiary’s drawdown, the flexibility and tax benefits have increased.

Many, therefore, see beneficiary’s drawdown as the ideal solution when cascading a pension fund to future generations. However, for some this will not be the ideal solution and could generate ill-feeling between those left behind.

On death, a pension fund is able to pass to a spouse, civil partner, dependant or anyone who has an expression of wish in their favour; known as a nominee.

The pension fund then becomes theirs and they can take withdrawals as and when they require with the tax position of these withdrawals being based on the age of the original pension holder at the time of death.

The new ‘owner’ of the pension fund then makes a nomination in favour of a successor. On the death of the nominee any remaining fund passes to the successor, who in turn makes a nomination for another successor who will benefit after their death, and so on. Each can take withdrawals as required and again the tax position is based on the age at death of the previous ’owner’.

Whilst this is a simple solution the person who accumulates the fund initially loses control over the destination of the fund once they die. The control of this fund becomes the nominee’s and they may have very different ideas.

Nominees and Successors

Take Tom and Barbara, a married couple who are in retirement and they have a son, Jack. Tom has accumulated a pension fund of £500,000 from which he is drawing an income. He has made a nomination in favour of Barbara so that when he dies the fund can pass to her as he wants to make sure she is financially secure in the event of his death.

Sadly Tom passes away, aged 70, and at that time Barbara becomes the new owner of the pension fund. The money passes to a beneficiary’s drawdown and she takes withdrawals from the fund with the occasional lump sum to fund holidays and other capital expenditure. As Tom died before 75 then the withdrawals that Barbara takes are tax free and her adviser reminds her that she needs to make sure a suitable nomination is in place to pass the fund on in the event of her death. She nominates their son, Jack, as her successor and this cycle continues until the fund is exhausted and there is nothing left to pass on.

When Barbara dies the fund passes to Jack who in turn will be able to nominate a successor, who will inherit the fund from him and be able to take withdrawals and nominate another successor.

As we have said, whilst this can be a simple and efficient way of passing on the fund to future beneficiaries, Tom has lost control of the destiny of the fund he accumulated during his lifetime. Whilst many will be comfortable with this there are a number of situations where this may create issues.

Building on the Tom and Barbara case study, Tom was previously married to Brenda who died a number of years ago and he had two children from this marriage; Nick and Jane. When leaving his fund to Barbara he expected her to look after Nick and Jane in the same way as Jack. However, since Tom’s death, Barbara had fallen out with Nick and Jane and therefore left the fund, in its entirety to Jack.

Tom’s sizeable pension fund has therefore completely bypassed two of his three children, but what could Tom have done during his lifetime to try and avoid this situation?

Using a pilot trust

Following the pension freedoms, many believe that pilot trusts, also known as bypass trusts, are redundant, but that isn’t necessarily so, especially in circumstances such as Tom’s.

A discretionary pilot trust is created during Tom’s lifetime. He appoints the trustees and makes a nominal settlement at outset in order to correctly constitute the trust. This gift will usually be covered by the annual gift exemption so no IHT issues will arise on creation. He should then provide a letter of wishes to the trustees explaining what his desires are for the trust and also make an expression of wish in favour of the trust so that on his death the pension fund is paid to the trustees.

So when Tom dies the fund passes to the trustees. His letter of wishes states that he wants Barbara to be catered for financially during her lifetime, so they can make distributions to her as they feel suitable, to meet her needs. On her subsequent death he wants the residual fund to be divided equally across his three children; Nick, Jane and Jack. The trustees have the option to either distribute the money to them or to continue to hold it keeping it out of a 40% tax environment and allowing it to skip generations and maybe go to Tom’s grandchildren.

The trustees have a greater range of options and flexibility than the ability to nominate to a beneficiary’s drawdown. They control a discretionary trust that can skip generations and allows them to pay benefits as they see fit, to cater for any unforeseen circumstances that may not have been anticipated when Tom was alive.

This flexibility does come with a cost though. There may be expenses in drawing up a trust deed at outset and if professional trustees are employed. The deed should be reasonably straightforward and Tom could ask friends and family to be lay trustees to help reduce the costs, and family and friends may have a better understanding of Tom’s objectives.

Distributions from the trust may not be as efficient as a beneficiary’s drawdown as the tax position would not be based on Tom’s age when he died – the trust would be taxable whatever age he was, or whatever age any of the possible nominees or successor were. This could be the same as if Tom had died aged 75 or over, so not necessarily a disadvantage in all cases.

The trustees could use an investment bond and distribute policies rather than cash, deflecting the tax from the penal tax charges that apply to discretionary trustees to personal assessment on the beneficiary. Similar to the rates that could apply to withdrawals from a beneficiary’s drawdown and making use of various allowances and lower rates of income tax. Top slicing would also be available to further reduce any tax payable.

There would be fees for investing the money, wrapper charges and fund charges – these would apply equally to a pension as to a trustee investment.

It may be more difficult to reduce the impact of periodic and exit charges, and these can add complication. Periodic charges will apply to a discretionary trust however they will not necessarily be on the tenth anniversary of the pilot trust. The trustees will need to consider when money first went into trust and should seek advice regarding this in order to establish the correct date when a return needs to be made.

The fact that Tom created a discretionary trust could have an impact on any other discretionary trusts he has created as they will need to share the basic rate allowance of £1,000 and the capital gains tax annual exemption, which is half the personal rate.

Trust or Drawdown?

While many clients will be happy with the structure of nominees, successors and beneficiary’s drawdown it will not be the best fit in all circumstances.

If an individual’s goal is to make sure that all their potential beneficiaries are catered for after death then a pilot or bypass trust could be a viable option. The additional cost involved with such an arrangement would need to be considered and weighed against the desire for the correct distribution of the pension fund that may have been accumulated over many years.

Unfortunately, the combination of death, family and money can cause friction. Tom could have seen two of his children left out from his inheritance so the periodic charge and potential increased running costs of a trust could have been a small price to pay to ensure that the benefits are passed to the correct person.

Some clients may have similar objectives to Tom so it is important to make sure that all options are considered and discussed.

Neil Jones is wealth management and tax specialist at Canada Life