chappie
Welcome to PPruNe. If you are who you claim to be (and I don't doubt it for a moment), please first accept my condolences, and my sympethy for your and your family's situation.
As far as I can see, the offending "clause" referred to in the Telegraph article is most probably Part V ("Reduction of Benefits") of the Armed Forces and Reserve Forces (Compensation Scheme) Order 2005 (Statutory Instrument No 439 of 2005). The most relevant sub-section here is "Reduction in benefit to take account of awards of damages".
Under that heading, Article 32 (at paragraph 1(b)) requires that the Secretary of State must first be satisfied that damages (meaning any payment) have been, or will be, recovered by someone in respect of the death of a person for which benefit is payable. He may then take those damages into account against any benefit which might otherwise be payable, and may withold or reduce any such benefit accordingly.
I think it is important to realise that the Article does not force the SofS to make such an adjustment; he could use his judgement as to what is appropriate. Secondly, under this article, he cannot make the reduction just because proceedings have been started; he must be convinced that they will succeed, and that they will lead to an award of damages (or other payment), or have already done so, or will certainly result in an out-of-court or other settlement involving the actual payment of some form of financial compensation.
There is no mention in this Article of the term "third parties" as used in the Telegraph report, so the Article will apply to "damages" arising from proceedings against the MoD itself. It may seem unfair to allow a reduction in this case, but remember that what we are talking about here is a compensation scheme payment, similar in principle in some ways to a pay-out from an insurance policy. It is common legal practice, and certainly common insurance practice, not to pay multiple awards for the same occurence. The SofS therefore has to consider whether it is right for the public purse to pay twice for the same thing. I know that this will sound harsh, but I only mean to help you understand the arguments that MoD is likely to raise.
Were the families in this case to take legal action for negligence and win, it is quite likely that the damages awarded would exceed the usual Service Attributle Pensions. In that case, the action would actually have succeeded in achieving a higher award, even if the SofS decided to make the adjustments allowed by the scheme.
Personally (and although I admit to being a Telegraph reader!), I think the paper has done you a disservice by reporting this matter under the sensational headline that it used. Nevertheless, you do have my sympathy and best wishes for the future.
Regards
Ginseng