The Wire: Spring 2022 – Pilot trusts explained

(Estimated read time 5 minutes)

Pilot trusts explained

In the 2014 budget, George Osborne introduced the biggest set of changes to pension rules since the great pension simplifications of 2006 – a misnomer if ever there was one. Included in the former Chancellor’s pension freedoms was a relaxation of the rules over how pension death benefits can be passed on. And with these changes the pilot trust, sometimes known as a bypass trust, appeared to be no longer needed. But there may still be situations where a pilot trust could be a useful tool.

What is a pilot trust? In a nutshell, it’s a discretionary trust set up with a nominal amount which is ready to receive further funds at a later date, most commonly pension death benefit lump sums or the pay out from a life insurance policy. A trust cannot be created without three certainties: the intention of the settlor; the subject matter (assets); and the objects (beneficiaries). Note the second certainty, the subject. There must be an asset in order to create a trust, so since the pension death benefit cannot arise in life, the trust must have some other asset on its creation – it is not uncommon to find a £10 note stapled to the trust deed.

So now we know what a pilot trust is, we need to understand what the old rules were in relation to pension death benefits, and why a pilot trust might be useful. Here, I am talking only about money purchase pensions, rather than defined benefit or final salary pensions. On death before age 75 where the pension fund hadn’t been touched, there were two options: a cash lump sum could be paid to any beneficiary and it would not be taxed; or a pension income could be paid to a dependant taxed at their marginal rate. On death before age 75 where the pension fund had already been accessed, or on death after age 75, these two options remained but the cash lump sum was taxed at a hefty 55%. The important point to note is that only a dependant could receive a pension income, all other payments to nominated beneficiaries were lump sum payments taking the cash out of the pension wrapper.

Why is this important? Well, a lump sum of cash going into someone’s estate immediately becomes assessable for Inheritance Tax, whereas cash staying in a pension, and paying an income, remains outside the recipient’s estate – a potential 55% tax charge on leaving the pension and a potential 40% Inheritance Tax charge.

The solution was the pilot trust. The pension holder would create a pilot trust and then nominate it to receive the lump sum death benefit. The spouse could be paid an income for life, or the trustees could simply make distributions as and when needed. But most usefully, the trust deed could include the right to make unlimited interest-free loans. So, by taking a loan from the trust the spouse still benefits from the lump sum but simultaneously creates a debt on their own estate. On their death the loan is repaid to the trust thus reducing their estate for IHT.

The changes introduced in the 2014 Budget removed the distinction over who could receive what from pension death benefits. The position now is that a pension holder can nominate whoever they wish to receive their pension on their death, it need not be a spouse or a dependant, and whoever that is can decide whether they wish to leave it untouched in a pension drawdown wrapper, take an income, or take the cash as a lump sum. It is entirely up to them (note this point for later), and crucially will be tax-free if the original pension holder died before the age of 75. On death after 75, anything withdrawn by the nominee is taxed at their marginal rate for income tax.

The fact that the nominee can receive the pension as a lump sum and keep it in a pension drawdown wrapper means that the IHT shield is retained. So, there is no longer a perceived need for a pilot trust… Or is there?

I said above that it is entirely up to the recipient what they do with the pension funds. The original pension holder can only nominate who, not how. You cannot nominate someone and stipulate that they can only have an income, for example. Nor can you nominate someone, a daughter for example, and specify that she must then nominate your grandchildren in the event of her death.

In a simple linear family situation this may not be important. You might be content to nominate your children, happy that they are sensible and in secure relationships. But what about a more complicated family set up? For example:

Scenario One

Charlie has adult children from his first marriage. He is on his second marriage and has several stepchildren. Charlie wants his second wife to receive an income from his pension, but he wants his own children to receive the lump sum on her death.

If Charlie nominates his second wife, he has absolutely no control over what happens next. Once she has received the pension, she could write her own nomination in favour of her own children.

Scenario Two

John, a widower, has adult children and five grandchildren. He would like to leave his pension to the grandchildren but worries about them receiving a large sum of money in one go when they are not mature enough to handle it.

For both these situations a pilot trust might be the answer. You can appoint trustees who you have faith will ensure your wishes will be met. Charlie could ask his trustees to ensure his wife receives the income she needs until her death and then distribute the funds to his children. John could appoint his children as trustees who will make sure the grandchildren will only receive funds when they are capable of handling them. And don’t forget that nominations can be changed at any time, so John could change the nomination in favour of his grandchildren once they’ve grown up, if he is still alive.

The downside? Yes, there has to be one, and it is tax, the extent of which depends on circumstances. Setting up the trust in the first place will be tax free, a £10 gift is easily covered by the exemptions, though of course there are likely to be one-off legal costs. The payment of the death benefits from the pension to the trust will be tax free if the pension holder died before age 75 (and the payment must be made within 2 years of death) and there is sufficient lifetime allowance to cover it.

However, if the pension holder dies after age 75, or under 75 but the two-year window is exceeded, the special lump sum death benefit charge of 45% will apply. That doesn’t sound too attractive, but there is an associated tax credit with this payment. This can be offset against the beneficiary’s other income in the tax year when distributions are made.

Then there are the 10-year anniversary charges on the trust. This is a complicated charge, made more so where the pension has been transferred before the member died, but that is beyond the scope of this piece (and if I’ve held your attention this long, I’ve done well!). But the 10-year anniversary charge can never be more than 6%.

Finally, the investments within the trust are subject to income tax on dividends and interest, and to Capital Gains Tax when assets are sold, taxes that investments are not subject to in the pension.

In terms of tax efficiency keeping funds within the pension wrapper will always be the best option, there is a cost to keeping control. For the majority, the usual ‘expression of wishes’ route will be all they need, but it is worth remembering that a pilot trust might be the answer where control is needed.

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