Michael Pashley, managing director of Practical Financial Exams Limited, looks at how paraplanners can use the state pension to meet death benefit objectives.
Regularly investing your state pension as a legacy for your loved ones can be both effective and tax efficient. Often, financial advisers are confronted by clients with death benefit objectives, but the humble state pension so often takes a back seat in favour of alternative strategies, sometimes including the transfer of a defined benefit pension scheme. But if regularly investing your state pension, how do the numbers stack up?
The simple cashflow model below demonstrates the nominal value of accumulated state pension assuming:
- The full single tier state pension of £9,339.20 per annum is paid, and subject to 20% Income Tax.
- The state pension increases 2.5% per annum.
- The accumulated investment achieves a 4% annualised compound return, net of charges.
- State pension starts being paid at age 66.
- The regular contributions to the accumulated investment are made annually in arrears.
The client’s age is represented by the horizontal axis.
The blue bars correspond to the right vertical axis and demonstrate the state pension increasing each year at a fixed rate of 2.5%.
The orange line corresponds to the left vertical axis. As we’re about to turn 87, broadly speaking average life expectancy in the UK for someone at retirement, our accumulated investment stands at £298,449. This more than doubles if we make it to age 97.
The challenge with accumulating state pension like this is tax. Accumulation into an ISA each year could be highly tax efficient from an Income Tax and CGT perspective but could attract IHT at 40%. Once you’re into your late 80s, based on our model, your nil-rate band has been used up purely by the state pension accumulation. IHT could be avoided using Business Relief qualifying investments. Furthermore, investment into EIS qualifying shares would provide Income Tax relief. However, we’d be limited according to our risk profile.
Gifting the money each year would be exempt from IHT because it’s a normal expenditure out of regular income  . However, if we’re gifting into a discretionary trust to invest and accumulate, it could be complex and tax inefficient to use collectives. We could use an investment bond, but there may be a limited number of regular premium investment bonds to choose from. We could avoid this problem by using the state pension to fund a Whole of Life assurance policy, in trust, to provide a known legacy. Alternatively, we could gift away our state pension income as we receive it, so we can watch our loved ones enjoying it in our lifetime.
Pension contributions of up to £3,600 (gross) could be made, and tax relief provided, up to age 75  . This would provide £720 relief at source and gross roll-up within the pension wrapper.
The point of all this is that state pension accumulation, or the use of the state pension to provide regular gifts to loved ones or to fund a Whole of Life assurance policy, is often overlooked. As per our cashflow model, once we hit our mid-70s, this ain’t chump change. This is a lifechanging amount of money. The deposit on a house. University costs. Private school fees…
So don’t count it out – the state pension is a great pension!
 Valuation Office Agency, “Inheritance Tax Manual Section 6: exemption,” 01 09 2021. [Online]. Available: https://www.gov.uk/guidance/inheritance-tax-manual/section-6-exemption. [Accessed 07 10 2021].
 HM Government, “Inheritance Tax Act 1984, Section 21,” 1984. [Online]. Available: https://www.legislation.gov.uk/ukpga/1984/51/section/21. [Accessed 07 10 2021].
 The Technical Team, “The Inheritance Tax, normal expenditure out of income exemption,” Prudential, 02 01 2020. [Online]. Available: https://www.pruadviser.co.uk/knowledge-literature/knowledge-library/normal-expenditure-out-of-income-exemption/. [Accessed 07 10 2021].
 HM Revenue & Customs, “PTM044100 – Contributions: tax relief for members: conditions,” 15 08 2021. [Online]. Available: https://www.gov.uk/hmrc-internal-manuals/pensions-tax-manual/ptm044100#ruki. [Accessed 07 10 2021].
 The Technical Team, “Tax relief on member contributions,” Prudential, 06 04 2021. [Online]. Available: https://www.pruadviser.co.uk/knowledge-literature/knowledge-library/tax-relief-members-contributions/. [Accessed 07 10 2021].
This article was first published in the November 2021 issue of Professional Paraplanner.