Unrevised pension schemes forgo major tax advantage

A COMPANY benefits package can be multifaceted and often includes a pension plan, a disability scheme, a death in service benefit and a group health insurance plan. And while many employees may be relatively familiar with the general terms of their pension plan - that is, whether it is contributory or non contributory, a defined benefits or defined contributions scheme - the terms of their death in service benefit may be less clear. Most people have an idea that the death in service payout represents a certain multiple of their salary, but few can state exactly what it is worth or the fact that the tax free value of the benefit may not exceed four times salary.

A number of Family Money readers have, on receiving their end of year pension benefits statements, discovered that their death in service benefit falls quite short of expectations.

One reader, Mr B, wrote to Family Money: "I only discovered recently, that 75 per cent of the death in service benefit from my company, which is calculated as a 10 times multiple of our projected pension income, is retained by the trustees who will administer it on behalf of my dependents. The other 25 per cent of the benefit can be paid out as a tax free lump sum, but only after negotiations with the trustees.

"Is this legal? Can the trustees with old what would seem to be the rightful entitlement of my dependents? Also I am very concerned that the life assurance policy that I took out separately is now wholly inadequate."

Mr B's company offers a defined contribution pension scheme and its death in service benefit has been designed - rather paternalistically - to make provision for the long term care of dependents should the employee die while still in service.

According to actuary David Rowell of Mercers Ltd, which specialises in employee benefit schemes, and Brid Horan, the head of actuarial services at KPMG, schemes in which the death in service benefit is calculated as a multiple of the projected pension were very common in older, established firms up to the 1970s and even the 1980s, but since then most schemes work it out as a multiple of salary," says Mr Rowell.

"We (at Mercers) recognised the weakness of calculating death in service as a multiple of pension expectations back in the 1970s, namely that it disadvantages employees with short service. Along with Irish Pensions Trust we did pioneering work in getting the Revenue to allow for a multiple of salary method of calculation. Not only does the latter method provide for people with shorter service but it makes it simpler for employees to understand exactly the level of benefit and also how much of it will be tax free. The Revenue allows a tax free benefit, equal to a maximum of four times salary."

Anything over that amount, he says, is usually paid to dependents as an annuity pension and different companies offer different amounts, but two, three or four times salary are the most common benefit values.

What is unusual about our reader's scheme, say our consultants, is the retention of 75 per cent of the benefit by the trustees to invest in the form of an annuity pension with just 25 per cent of benefit paid out as a tax free lump sum.

"The biggest disadvantage of this method," says Brid Horan of KPMG "is the loss of the majority of the tax free lump sum which can be worth up to a maximum of four times salary. When a company buys an annuity on behalf of an employee, the pension is taxed as income. If an individual buys an annuity on their own behalf, depending on their age and life expectancy, only a portion of the pension income may end up taxed." This is because the Revenue accepts that the person, because of their limited life span, may be the recepient of their own capital sum.

Ms Horan also points out that if the beneficiary of the death in service benefit is a relatively young person, the value of the pension which is purchased by the company will be considerably lower than if they were older, annuity rates being based on age and sex (women live longer and therefore are quoted lower rates.) A young widow, for example, may be left with a pension of only a couple of thousand pounds a year but might have been able to secure a far better investment return from a tax free lump sum.

Employees of schemes which retain a sizeable chunk of death in service benefit and who are not aware of the workings of the scheme may very well be under insuring themselves. Our reader thought his beneficiaries would receive a sizeable death in service benefit and topped up his life cover by only a modest amount. Others may also be in such a position and should certainly review their insurance accordingly, keeping in mind that life insurance rates increase considerably over age 40.

Finally, schemes which retain a percentage of the death in service benefit for the purchase of annuities for dependents are perfectly legal. It is entirely up to the employer to decide the benefits package in his company but the terms of a scheme can be changed if it is recommended by the trustees and the employer agrees.