In this month’s article, the Aberdeen technical team considers the factors affecting quality of life in retirement and whether beneficiaries of pension pots will be any worse off under the proposed IHT on pensions rules than now.
The introduction of IHT on pension death benefits from April 2027 has understandably created a planning issue for both paraplanners and clients alike. Something clients have been saving into for their entire working lives will be back in their estate for IHT. It raises the question, should pension funding continue with the double risk of IHT and income tax for post age 75 death benefits?
However, the reality is that many individuals simply aren’t saving enough to fund their desired standard of living in retirement. These individuals are at more risk of outliving their pension pot than paying IHT on it.
How long will retirement last?
When the Basic State Pension was introduced in 1948, the State Pension Age was 60 years for women and 65 years for men. The average life expectancy around this time was 66 for men and 71 for women, meaning a relatively short retirement.
Today, a 65-year-old male has an average life expectancy of 86 and a 1 in 4 chance of reaching 94. For females aged 65, life expectancy increases to age 89 with a 1 in 4 chance of reaching 961. Even those retiring at State Pension Age could still have two decades of retirement ahead of them to fund.
The risk remains that some clients will die at an early age and will have spent little or none of their retirement savings. This is where the greatest threat from IHT exists. Any additional liability from the inclusion of the pension within the estate may be mitigated by taking out life cover under trust. The sum assured need not be limited to the extra IHT but may also include any income tax the beneficiary may face if the death is after age 75.
Understanding the cost of living
An independent report by the Pension and Lifetime Savings Association2 (PLSA) released in February 2024 calculated what a single person and a couple would need each year to achieve a “minimum”, “moderate” and “comfortable” standard of living.
The full New State Pension is £11,973 a year in 2025/26, meaning there could be a significant shortfall for those retiring with little pension provision who want to enjoy a more comfortable retirement.
It should also be noted that the figures quoted are after tax, so a single person targeting a “moderate” retirement would need gross income of nearly £36,000 a year. Assuming they retired at 65 and were entitled to the full New State Pension at 67, they would need a fund in the region of £600,000* to meet the “moderate” standard of living with their income increasing each year by 3%.
* Assumptions
• Investment growth of 3.5% net of charges
• Fund exhausted after 25 years
• £64,000 tax-free cash used to meet income in first two years.
Long term care
Those who meet, or exceed, average life expectancy are also more likely to need care in later life, further increasing the costs of their final years. The research by PLSA does not include the potential costs of later life care and these could significantly increase the cost of retirement.
Current research3 indicates that the average cost of residential care in the UK is £1,266 a week, increasing to £1,554 a week for dementia nursing care. With life expectancy in care homes ranging from 2.2 years for males aged 90 and over, and 7 years for those aged 65-694, costs could quickly reach six figure sums for those who must fund their own care.
The impact of inflation
The cost of living will also increase year on year as inflation bites. The state pension increases with inflation, so do defined benefit pensions. Annuities can have escalation included but at an upfront cost. Drawdown income can be adjusted year-on-year to meet rising costs, but investment returns will dictate a sustainable level of withdrawal.
To put the effect of inflation in perspective, an individual who retired in 2015 with annual expenditure of £20,000 would need £27,218 today to maintain the same standard of living, assuming all of their costs had increased by CPI5.
This figure increases to £34,845 had they retired in 2005 and their £20,000 cost of living doubles to £40,509 had they retired in 1995.
The worst case scenario
Unused pension funds face the double whammy of IHT and income tax where the client dies after age 75. Of course, this will also apply to those who will never need their pension pot in retirement and pension saving to date has been motivated by a tax efficient way of transferring wealth.
Even if IHT and income tax on beneficiary drawdown becomes a reality there is still a convincing argument to continue funding. The beneficiary will be no worse provided their tax rate is no greater than the tax relief on the member’s contributions.
For example, for every £100 of gross contribution to the pension the net cost to a higher rate taxpayer will be £60. Had the £60 remained in the estate rather than paid into the pension, IHT of £24 (£60 x 40%) would be due leaving the beneficiaries with £36 (£60 – £24).
The £100 in the pension on death after 75 would suffer both IHT and income tax at the beneficiary’s marginal rate. IHT is deducted first, leaving £60 to be paid to the beneficiary.
• If the beneficiary is a basic rate taxpayer, they would have to pay £12 (£60 x 20%) in income tax giving them a net amount of £48.
• For a higher rate taxpaying beneficiary, the amount after income tax would £36 (£60 x 40%), the same as if the amount had been invested outside the pension.
The net position for the beneficiary will only be made worse by saving in a pension if their marginal income tax rate paid on withdrawals is greater than the tax relief obtained on the contribution.
These examples ignore investment growth, but of course saving within a pension means investment returns are sheltered from income tax and CGT.
Conclusion
This is an emotive issue. But whatever your thoughts, imposing IHT on pensions has in one respect levelled the playing field, with all mainstream tax wrappers now subject to IHT. And it leaves those that had already accumulated pension wealth that they intended to pass on with a much greater IHT liability than they anticipated. But before taking any drastic action, it is important to understand the likely cost of retirement.
But it certainly should not be seen as barrier to those still saving into their pension. Pensions remain the most tax efficient long-term savings vehicle for the vast majority of clients, whether that is for retirement or wealth transfer.
1 Life expectancy calculator.
2 https://www.retirementlivingstandards.org.uk.
3 https://www.carehome.co.uk/advice/care-home-fees-and-costs-how-much-do-you-pay.
4 Life expectancy in care homes, England and Wales – Office for National Statistics.
5 https://www.bankofengland.co.uk/monetary-policy/inflation/inflation-calculator.
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