IHT on unused pensions

How will the new IHT hit on unused pensions affect retirement income planning, especially annuities?

Labour’s 2024 budget did not change the rules on tax-free cash as many pundits forecasted but it will bring unused pensions into IHT calculations from April 2027.

At present, when someone dies, any unused pensions and death benefits can be paid to beneficiaries without attracting IHT but this will all change in three years’ time. Under the new rules, the value of unused pensions and death benefits will be added to a person’s estate and therefore maybe subject to IHT.

Since the introduction of pension freedoms in 2015 many advisers and their clients viewed pensions as a tax-efficient and flexible pot of money that could be left to their family rather than an income producing asset. Many advisers talk about using pensions for inter-generational planning; that is passing on wealth to children and other family members. Consequently, less annuities have been arranged and pension drawdown has become the default option for many people.

So will the introduction of IHT on unused pensions reverse this trend and will advisers start placing more emphasis on using pensions to pay income rather than as NIDs (no income drawdown)?

I think it is likely that pensions will be used less for passing wealth to the next generation and more for paying out an income during retirement. If this will be the case, will we see more annuities being arranged?

Although many higher net worth individuals who may fall into the new IHT trap will be comfortable taking income by way of pension drawdown, the case for arranging annuities, will in my view, become increasingly stronger for the following reasons:

• Annuities are a hard act to beat for maximising income
• Joint life annuities are a good way to provide peace of mind and security for surviving partners
• The new IHT rules may help solve the ‘annuity puzzle’

If the objective is to take money out of a pension fund in order to reduce its future value then annuities are a good option because they are the best way of maximising income without taking undue risks.

Although lump sum payments on death is an attractive option, many of my clients recognise the benefits of leaving their spouse or partner with a guaranteed income. I remember one high profile client telling me he was worried that when he died his wife wouldn’t cope with having to making complicated financial decisions and it would be better if she received the income from a joint life annuity.

Finally, if the new IHT rules reduce the attractiveness of leaving pension funds to the family it may help solve the annuity puzzle. This highlights the gap between economic theory and real-world behaviour; if annuities provide the most efficient way to pay income for life, why don’t more people buy them?

The main reason is that many people place more importance on leaving an inheritance over maximising income during their life because they underestimate their life expectancy.

So, if using a pension for inheritance purposes becomes less attractive, will annuities become more attractive?

William Burrows runs the Annuity project and is a financial adviser at Eadon & Co