Ever since the announcement on 30 October 2024 during the Autumn Budget that discretionary pension schemes will move into the IHT net, annuitisation and whole of life have been mooted as a possible answer.
In reality, it may be a lot more nuanced and there will not be a one-size-fits-all answer.
The key thing to remember is that the stated aim of this change is to bring pensions back to what they were pre-pensions freedoms: a vehicle to fund your retirement and not to pass wealth down the generations.
To achieve this, you will need to do careful analysis on what pension assets the client will have and categorise the pension in a RAG rating. Green being what you will definitely need for your retirement, amber being what you may need (after stress testing on models etc), and red being the money you will never need and had probably earmarked to go to the next generation IHT-free.
The gut feel on this (as annuities without value protection or guarantee periods will be out of scope for IHT) is that annuitising your red money and getting a whole of life (WOL) plan in trust will solve the issue.
The stated aim of this change is to bring pensions back to what they were pre-pensions freedoms
This, of course, assumes that the premiums will be paid using the gifts from normal expenditure of income rules. To use this, the clients lifestyle has to be unaffected, and more importantly covered by net surplus income.
If the client is using any capital for living expenditure then this will not count and your premiums may then become potentially exempt transfers or chargeable lifetime transfers, depending on if your trust is bare or discretionary respectively.
There are issues of insurability, from a health and financial underwriting perspective. The earlier you start a WOL plan, it’s likely your client will be healthier.
But for those with underlying health conditions they may not be insurable. The longer this is left, that’s more likely to be the case. Will the client be rated, and how would this affect the cover purchased compared to the red money that they have?
Also, there’s a risk that if this option becomes popular, WOL providers may tighten their financial underwriting rules i.e. are you taking this policy to cover a IHT bill, or create a legacy.
Inherited pensions will be subject to IHT from 2027
Perhaps WOL could be discounted based on the clients health, or perhaps the client doesn’t see the value in protection, or they may want to be able to pass this red money on during their lifetime. Alternative options will have to be pursued. But even if they are accepted on standard terms, that’s when the assessing the variable and number crunching begins.
But assuming that we are looking at the WOL option, do you fund this from an annuity, or from the drawdown pot? In the early years, the drawdown option will provide a higher legacy (as there is a pot to pass on, as well as the WOL). But if using drawdown and death over 75 is likely, what is the tax position of the beneficiary?
Is there a risk of the policy lapsing, either from drawdown pot depletion or care home and mental capacity issues?
Do you want a guarantee period on your annuity to protect the value passed on after death? Would you be comfortable with your beneficiary receiving this in instalments? If not, an annuity may not be the best option.
If you do choose a guarantee, the key questions then become how long to set it for and what the probate value of the annuity will be on death.
Given the multitude of variables, very good cashflow modelling or excel calculations will be necessary to evidence the best approach
Is there an age at which leaving the red money untouched to accumulate would actually produce a greater payout than a WOL plan plus any annuity guarantee, once IHT and the beneficiary’s income tax are taken into account? If so, that needs to be clearly shown to the client.
A WOL plan may provide security, and in the early years it carries the added “benefit” that if death is unexpected, the beneficiaries could receive a larger windfall.
Alternatively, could the income from an annuity or drawdown pot be gifted instead? By funding pensions for loved ones, you reduce IHT, they benefit from tax relief, and if they are in a higher tax band, they may also receive further money back from the government. At a certain point, this route may prove to be the most effective outcome.
Some options may be discountable, but given the multitude of variables, very good cashflow modelling or excel calculations will be necessary to evidence the best approach for clients.
Mark Devlin is senior technical manager at M&G
