Risk Benefits, DC Flexibility and Pension Scams
From 6 April 2015, the way in which people can crystallise their accumulated DC pension savings at retirement has changed. No longer do people have to use the pot they have built up to buy an annuity, giving them a regular source of income once they have retired, but they have a number of other options available to them. Indeed, they do not even have to wait until they retire. This new flexibility in the legislation is subject to what the rules of the pension scheme allow.
Now, members can choose to take their pension pot as a single (or series of) lump sum(s) and use this in any way they wish to. The popular press have warned about individuals using their long term built up pension savings to buy cars or holidays, but the concerns of the industry and government have focused on the potential for individuals to be persuaded to use the cash to invest in other financial products that may be unregulated, have high charges and in some instances be illegal. Various initiatives to highlight the risks to members when crystallising or transferring their benefits have been introduced so scheme administrators can adopt a standard approach.
Quite rightly this should be the main focus. Choice on retirement should not be to the detriment of the saver. As such this focus has meant that other areas of financial planning may be overlooked – and one of these areas is risk benefits.
Whilst in recent years there has been a move away from the linking of pension benefits and life assurance benefits through occupational pension schemes, there still exist many occupational schemes which have life assurance benefits written under the scheme. Under such schemes, individuals may only be entitled to life assurance benefits where they remain active members of the pension scheme.
Therefore, this throws up a number of questions that may or may not have been considered by employer and employee/member alike when they elect to crystallise all or some of their pension pot, namely:
- If a member elects to crystallise some or all of their pension pot earlier than normal retirement age, and remains in employment, do they continue to be covered for death in service benefits/or is there a reduction in their death in service cover?
- Crystallising pension benefits before retirement will reduce the individual’s available lifetime allowance, which means that a death in service event may trigger an unplanned large tax charge should this further crystallisation event (i.e. lump sum death benefit) take their benefits over the LTA limit.
- Additionally, there are questions around the effect on group income protection benefits in payment. If the person in receipt of GIP benefits decides to elect to crystallise some or all of their pension pot, this may be viewed by the group income protection insurer as additional income which could reduce an employee’s incentive to return back to work if fit and well enough to eventually do so.
Group Life Assurance Considerations
In terms of delinking pension benefits and life assurance benefits, the intention of the employer must be established. Is it the intention to reduce life assurance benefits for those electing to crystallise some or all of their pension pot and remaining in service where life assurance benefits are linked with being an active member? Or is it the intention that the death benefits should not be reduced whilst the individual remains employed?
If the former, then nothing needs to be changed. However, if the latter, amendments may need to be made to both the pension scheme rules and the insurance policy (if insured).
Eligibility and Policy Amendments
Changing the insurance policy is relatively easy and the amendment can be made at any time. However, there may be requirements from the insurer for any employee crystallising some or all of their pension pot and retaining life assurance benefits (where previously this was not permitted if pension was taken) to be actively at work. That is, the individual must be present at work in his or her normal capacity carrying out the fundamental duties of his or her occupation. Where an employee does not satisfy this, the cover might not be retained. It is for this reason that individuals may need to think about their decision to elect to crystallise their pension pot whilst also considering their health circumstances before doing so.
Even if the employer does not allow the individual to retain life assurance cover on electing to crystallise some or all of their pension pot, will the individual be able to buy replacement or like for like life assurance cover on the individual market where medical underwriting would be required?
As such, we envisage that most employers will from a paternalistic point of view enable employees to retain life assurance cover where previously crystallising pension benefits meant losing life assurance benefits. The cost to the employer would not normally change.
Trust Deed and Rules
With regard to the Trust Deed and Rules that governs the provision of group life assurance benefits and potentially also the pension benefits, consideration should be given as to whether the Trust Deed and Rules needs amending to reflect any change to whether employees crystallising their pension pot can retain life assurance benefits.
For those occupational pension schemes that still govern death benefits, there will need to be an amendment to the Trust Deed and Rules where changes to the eligibility for life assurance benefits are to change where employees crystallise their pension pot. As such, legal advice should be sought in this regard.
Previously, and for the majority of schemes where this was the case, we would have advocated a separation of death benefits from the pension benefits under a trust by setting up a new Stand Alone life Assurance Trust, which normally has its rules imbedded in the policy documentation of the insurer at the time.
However, whilst there are still many advantageous reasons for doing this, the rise of pension scams since the change in legislation has seen increased administration for setting up and registering Stand Alone Life assurance schemes with HMRC (albeit inadvertently). As such, employers and potential trustees to new Stand Alone Life Assurance arrangements should be aware of this.
Group Income Protection Considerations
Whilst DC flexibility would seem to have more in common with life assurance benefits, employers need to be mindful of the effect of crystallising pension savings early or in full before retirement in relation to group income protection benefits.
Firstly, it needs to be considered whether crystallising their pension pot means that employees remain as “employees of the company” rather than retired or having left service. This is because group income protection benefits and the insurance that funds these benefits, are dependent on the employee having a role to return to if the employee were to go off absent.
Whilst this seems obvious, we have witnessed claim forms come in from employees that state the individual is “retired” or a “pensioner”. The insurer will interpret this as not being in work whereas the employer means that the individual has just crystallised some or all of their pension pot. Again this just requires a simple changing of the policy document and again should be cost neutral to amend.
The bigger concern however relates to those employees who are actually claiming GIP benefit. That is, they are receiving a regular income from the insurer due to being unable to work for reasons of illness or injury.
As outlined, insurers pay benefits in accordance with a number of terms and conditions. One is that there must remain a financial incentive for individuals to return to work where benefits are paid, hence only a maximum of up to 75% of salary being paid under a policy.
Where a person claiming benefits elects to crystallise some or all of their pension pot, the financial incentive is greatly reduced. Under the insurer’s terms around income from other sources, the insurer reserves the right to withdraw or cease paying benefits to the individual where it is felt there no longer remains a financial incentive to return to work.
Claimants and their employers should be mindful of this. Normally, the reduction by the insurer relates to other regular incomes such as mortgage or credit card protection insurance. Often lump sum benefits will not be taken into account by the insurer when considering reductions in benefits, but obviously where large lump sums are crystallised from pension pots (e.g. uncrystallised funds pension lump sum), the financial incentive to return to work can be greatly reduced.
As such, most insurers have moved to allow anyone crystallising up to 25% of their pension pot not to be considered for a reduction in benefits. Anything over and above this will be considered on a case by case basis. For instance, a number of insurers have said they would be unlikely to reduce the group income protection benefit by any amount, if the individual is crystallising some or all of their pension pot due to greatly reduced life expectancy. That is, there is minimum chance of the individual reaching retirement age due to medical prognosis, and therefore they are crystallising their pension pot early.
Therefore, any long term absentee thinking of crystallising their pension pot early, should consider the effect on group income protection benefits before doing so.