Life cover for high earners - are senior employees and their beneficiaries at risk, asks David Pugh
Headlines about the hardships of high earners do not garner sympathy, particularly during a recession. The fact remains though that the financial landscape is changing rapidly for this group at the moment, and employers should act quickly to protect senior staff.
Whether it is the 50% income tax band for those that earn over £150,000, introduced by the Chancellor in this year's Budget, or the 2006 (A-Day) lifetime allowance, which limits the amount individuals can accumulate in their pension, high earners seem to be penalised from almost every direction.
In addition to these high profile changes the life cover schemes of this group are also potentially at risk. This could have a dramatic effect for, not just high earners themselves, but also their beneficiaries (who receive a lump sum in the event of the employee's death in service).
Life cover is often included in an employee benefits package. The onus rests firmly with business owners and managers to provide accurate and up-to-date information for all their staff to ensure they fully understand the package they are receiving. Part of this responsibility includes recognising the potential vulnerability of their high earning staff, and taking appropriate steps to protect them.
If a benefits package incorporates a Death in Service scheme, a company should ensure that beneficiaries receive the money - the lump sum - they are expecting, in the event of the employee's death. This may seem obvious, but in reality there are a number of issues that can restrict the level of cover that high earners can obtain. The three most significant are: the free cover limit; the earnings cap; and the lifetime allowance imposed. There are a number of ways in which individuals and their employers can work to ensure that high earners receive the cover they are entitled to. But, as always, it is a question of communicating the issues and providing senior employees who could be affected with high quality, objective and independent financial advice.
• Free cover limit:
A group life scheme will include a level of benefits which an insurance company is happy to cover without asking for medical evidence. This 'free cover limit' relies upon the law of averages and the employee base being big enough for the lower risk staff to balance out the higher risk individuals. The objective is to create both cost and time savings for the employer.
However, the cover provided by the insurance company is typically a multiple of an employee's salary, and the drawback for high earners is that they usually earn well above the free cover limit. As a result they will often be required to undergo medicals, questionnaires and the full underwriting process. This may create a massive cost increase for the employer; there is even the possibility that cover will be declined.
Many high earners tend to be older, time poor and - in many cases - lead stressful and busy lifestyles. Overall, obtaining the required level of cover for high earning individuals can present a challenge for all parties involved.
• Earnings Cap
Cover is usually expressed as a multiple of salary and historically (prior to 6th April 2006) has been capped, but many companies still opt to use the Inland Revenue cap (£123,600 this year). In such cases benefits for high earners are restricted and they do not receive the multiple of salary they could.
Ironically this need not be the case. Many firms are simply unaware that following changes to pension rules in 2006, group life cover schemes operate under pension scheme rules, as such they are treated as a pension and the earnings cap need not apply.
As it is obsolete employers can simply remove the cap and allow high earning staff the full multiple of salary that they are entitled to, rather than being restricted to ‘capped' benefits. The downside for companies is that an increase in cover will result in higher costs, but do staff realise that these benefits are capped? And are companies today actually informing their employees?
In order to address this, some businesses have put in place a higher multiple of salary for senior staff, but restricted the lump sum to a fixed multiple of salary (up to 4 times); the balance is used to provide dependants' pensions. Given the fact a lump sum is tax free, and pensions (whether to children or spouses) will be taxed as earned income, their removal should improve benefits without increasing costs.
• Lifetime Allowance
Because group death in service schemes are legally defined as pensions, the lump sum payable to the employees beneficiaries on death can be added to an employee's accrued pension funds and tested against the lifetime allowance in the event of a claim. And, many need to remember that pension funds in excess of the lifetime allowance would be taxed at 55%, which would be payable by the beneficiary.
To be clear on what this could mean in practice; should the deceased's pension exceed the lifetime allowance - once the death in service payment is added to it - the beneficiaries will be liable to a tax charge at 55% on the excess.
The lifetime allowance may seem high at £1.8 million (from April 2010), but it is set to be frozen at this level until at least 2016. High earning individuals can potentially breach this fairly easily, in many cases without realising they have done so.
The following case study examples provide employers with some guidelines as to which of their employees might be 'at risk':
The following examples are based on 2009/10 Lifetime allowance of £1.75m
Director - Adam:
Earns £150,000 and has life cover of 10x salary. He has a deferred final salary pension of £20,000 pa and Group Personal Pension valued at £100,000.
On death, his beneficiaries would have a tax bill of £137,500
High Earner - Belinda:
Earns £250,000 and has life cover of 4x salary. She is in receipt of a pension of £35,000 pa and has no other pension benefits.
On death, her beneficiaries would have a tax bill of £68,750
Key Employee - Charles:
Earns £300,000 and has life cover of 8x salary. He has a SIPP valued at £750,000.
On death, his beneficiaries would have a tax bill of £770, 000.
Please note: These above tax charges would be due if benefits were taken as a lump sum.
It is possible to arrange a more tax efficient structure; dependents could agree to take the excess as a pension for example, although there would be a tax liability on each payment made. Employers could also put affected individuals into a separate scheme, that provides the same level of cover, but - crucially - is not a pension.
This can usually be achieved without incurring any further underwriting or immediate cost, but the process is time consuming and requires some attention and planning. However, I believe it could be an important piece of work for business leaders keen to retain the most senior members of their workforce - particularly important during these difficult economic times.
Employers who are serious about making their business as attractive as possible to the highly skilled and highly remunerated should consider this approach as part of a broader, regular review of cover arrangements for all employees earning over £125,000.
It is clear that the responsibility is with today's employers to check they have the correct information in relation to each employee, including details relating to pension schemes from previous jobs. High earning should be guided through what is a highly complex issue, to avoid being caught out. Whilst these individuals may be financially savvy, they may not always have the time to ensure their affairs are in order.
As ever, it it pays to look after your employees.
David Pugh is senior partner at Foster Denovo
