What's a pension really for? #085
A sexy title I know, bear with me...
Listening to a dour presenter droning on about the taxation changes to pension death benefits at a recent conference it suddenly struck me - when did pensions become a way to pass money down the generations, mostly favouring those with more?
Hardly the purpose for which they were intended.
Let me explain by taking you back to the beginning.
Once upon a time
Once upon a time, some bright individuals realised people need an income source when they stop working so they aren’t reliant on their offspring, wider family or the state. Thus, pensions were born.
Because we humans are not very good at imagining ourselves many years into the future, nor are we very good at forgoing less today in anticipation of tomorrow, pensions, which after all are just glorified savings schemes, were given special tax sweeteners:
Income tax relief on contributions
A sympathetic tax environment during the period of investment growth, and
At retirement, 25% of the pension fund available tax-free
The enticements worked and the popularity of pensions started to grow. But the tax benefits didn’t stop there. A privileged tax position existed on death.
How death benefits evolved: a timeline
This is a tad complex so stick with me!
Until 1995 - On death before age 75 or annuity purchase (whichever came first), pension death benefits varied from as little as a return of the contributions paid up to the value of the pension fund. These benefits were mostly tax free.
In those days, the only income option at retirement was to use the pension fund to buy an annuity. An annuity is basically a guaranteed taxable income stream paid for life from an insurance company.
If the annuitant (and their spouse or dependant if a joint life annuity had been bought) died early, the annuity provider ‘won’ —they kept any unpaid money in the annuity ‘pool’. If the annuitant lived long, the annuitant ‘won’1—they received more back from the insurance company than they paid in.
Crucially, no return of the pension fund was available after an annuity was purchased.2
1995-2011 - From 1995 to 2011 the purchase of an annuity ceased to be compulsory until age 75. Instead, the pension holder could draw down a taxable income from their pension fund from age 50 (rising to age 55, with income within certain parameters), a bit like a bank account.
On death before 75, any pension fund remaining from which drawdowns were being paid (crystallised) was subject to a 35% tax charge before being paid to the deceased’s nominated beneficiaries. Any undrawn pension fund (uncrystallised) could be paid tax-free.
On death at age 75 and beyond there continued to be no capital return from the annuity (see note 2 below).
2011-2015 - In the four years between 2011 and 2015 the need to buy an annuity at age 75 was removed but the death tax charge increased to 55% for any pension fund (crystallised) already in payment. Uncrystallised funds remained tax free. The same 55% tax charge also applied to any remaining pension fund paid to beneficiaries on death after age 75.
2015 - In 2015 George Osborne introduced the so-called ‘pension freedoms’.
On death before age 75, ANY pension fund (crystallised or not) up to the Lifetime Allowance (the maximum one could accumulate tax free in pensions, then £1.25 million) was available tax-free to any beneficiary.
Remarkably, the pension fund could also be designated as a ‘Beneficiary’s Pension’ (rather than a lump sum) with any resulting income paid tax-free. If the beneficiary subsequently died before their age 75, any of their remaining Beneficiary’s Pension, could be passed to their beneficiary tax free...
Overnight pensions became a multi-generational wealth transition tool much loved by financial planners and their clients.
On death at age 75 or beyond, any pension fund remaining was taxable at the beneficiary’s personal rate of income tax.
The 2024 reset
This gloriously benign tax environment all changed at the last budget when the Chancellor decreed that pension funds left to anyone other than a spouse, civil partner or charity would be subject to inheritance tax from April 20273
Shock! Horror! Exclamation! How dare the government take our pension pots from our families!
But is that really true?
Implications
At face value I get it. Nobody likes to feel like they are losing something. And this change is manna from heaven for clickbait headlines.
Of course, knowing what we know now, some may have chosen to gift or spend money rather than make pension contributions were it not for the favourable inheritance tax position.
And it’s true the way HMRC has indicated that inheritance tax will be calculated on pensions will add complexity to the estates of some.
In addition, some estates and beneficiaries will face cliff-edge inheritance tax rates as reliefs such as the Residence Nil Rate Band are tapered away. And the beneficiaries of those who die over age 75 could potentially face a double tax charge - both inheritance tax on the estate and income tax on the balance received.
I get this. Edge cases will always exist.
I do also acknowledge these changes mean my financial planning friends will be busy grappling with yet more changes to pensions and taxation whilst trying to explain the change of plans to their clients. Some might say that’s good for business *wink*.
Perhaps the biggest negative impact is the public’s perception that they can’t trust the government with their money.
Fit for purpose
Although some are critical of these changes it wasn’t so many years ago no pension fund money would have been inherited by the family once the pension holder bought an annuity, or got to age 75.
I would argue pension funds shouldn’t have become an intergenerational tax planning tool usurping the reasons for which pensions were intended, for some at least.
While I understand the concerns, the changes from 2027 perhaps restore pensions to their original purpose - as a means of income post retirement.
You
I’ve had my say. And I must admit reminding myself of all the pension death benefit tax changes over the years has made my head hurt... It’s also made me wonder why pensions have fallen outside of the inheritance tax net for all these years anyway. And when on earth will the government stop changing the rules!
But as ever, I’m interested in you.
Whether you are part of the financial planning community or someone in or approaching retirement, I’m interested in your thoughts.
What do you think of these pension changes?
What have I missed in my thinking?
What could have been done instead?
Pour yourself a stiff drink, you’ll need it, and drop me a line, I’d love to hear from you.
And remember, you’re never going to be any younger than you are today, take a quick check on your pension death benefit nominations - do they still reflect what you want?
Until next week my friends,
Ruth x
Ps This is a tricky one - if you have any questions and you’re not sure how this affects you drop me a line and I’ll send you some pointers.
Thank you for reading 1000Weeks – I hope you enjoyed it. If you did it’d put a skip in my step if you left me a comment, like, shared or subscribed. 😊
‘Won’ may sound a somewhat trivial term when talking about death, yet a bet on one’s own mortality is exactly the gamble I used to discuss with my clients when deciding whether to buy an annuity or not.
Unless an annuity was purchased with a guaranteed period during which a death benefit of the remaining guarantee may be paid.
If the pension holder dies before 75, the fund remaining after inheritance tax is income tax free. Any fund remaining on the pension holder’s death from age 75 is subject to inheritance tax and the beneficiary’s personal income tax rate. Death in Service payments will remain tax free.