The unintended consequences of the inheritance tax changes for Defined Contribution pensions
17 December 2024
David Parfett, Head of Employee Benefits, discusses the proposed changes to inheritance tax announced in the autumn Budget. He asks whether we’re likely to see two unintended consequences – excessive drawdown of Defined Contribution pension pots and a resurgence in the annuity market.
In the shake-up of UK pensions over the past decade, one important consequence of pensions freedoms is easily overlooked – annuity purchase at retirement is no longer the ‘default’ option. Instead, people are free to use their funds as they wish – drawing down income whenever they like or even cashing out their funds.
There are many debates to be had about the wisdom of pension freedoms and the speed with which they were introduced. On the one hand, people are now free to make good decisions in line with their personal needs and circumstances. But on the other hand, they’re equally free to make bad decisions, which may result in paying more income tax than necessary or even running out of money.
How pension freedoms changed DC pensions
Pension freedoms had a dramatic effect on Defined Contribution (DC) pensions and their usage.
Traditionally, pensions have been vehicles that provide an income in retirement. Defined Benefit pensions still do that, of course, but it’s worth remembering that in the past, Defined Contribution pensions were also seen as retirement income generators. They were savings vehicles which people used to buy an annuity when they retired, usually after taking their tax-free lump sum.
While there was some flexibility around how and when they did this, for most people there was no alternative to an annuity.
At the time, there was much debate about the pros and cons of annuities. Many people were concerned about the lack of choice, and annuities acquired a reputation – rightly or wrongly – for delivering poor value for money. Over the years, the cost rose considerably, and much of the value was lost if someone died soon after the start of their lifetime annuity.
The pension freedoms changed all that, allowing people to choose how and when (from a specified minimum age) to access their funds.
Estate planning and DC pensions
The impact of pension freedoms on estate-planning decisions gradually came to light.
DC pensions are typically set up under a discretionary trust, meaning that on death the funds remaining in the pension pot can be paid out to a ‘nominated beneficiary’. This arrangement falls outside the estate for inheritance tax (IHT) purposes.
With pension freedoms and the various ways that people now took their benefits, an individual could access their fund without withdrawing it in full. Death made no difference to the treatment of the remaining amount.
This changed how some people perceived their pensions. Rather than seeing it as a means of providing a retirement income, they treated it as a savings vehicle which provided significant tax advantages on death.
And that’s where the 2024 autumn Budget came in.
This increased use of pensions as an estate planning vehicle to avoid IHT hadn’t escaped the notice of HM Treasury, which resolved to clamp down on it.
They are doing so by bringing pensions into the IHT regime. From 2027, most unspent pension funds will form part of an individual’s estate. The exact details are subject to consultation, but HM Treasury is proposing to add any unused funds to the overall value of the estate. If the estate has a total value of more than £325,000 (or £500,000 if the home is left to a direct descendant), then the assets will be liable to IHT at 40%.
To clarify, all or part of an estate that is left to a spouse or civil partner will not attract IHT.
We can now expect to see further significant changes in the way people – and not just the wealthy – approach their estate planning once the autumn Budget changes to IHT are bedded in.
Can we expect changes to DC pension drawdown?
My colleague, Andrew Overend, recently made a valuable point about a possible unintended consequence of the autumn Budget IHT changes.
In his blog post, The autumn Budget and Defined Contribution pensions – Rumours and reality checks, he argued that up to now pensioners have been more likely to take a cautious approach to drawdown, knowing that any unspent amount can be passed to their beneficiaries tax-free.
Taxing leftover pension savings at 40% upon death, on the other hand, may encourage “excessive early drawdown of pension savings and increase the number of pensioners becoming dependent on the state in later life”.
The return of annuities?
Alongside any changes to estate planning and drawdown, a more unexpected change may be a resurgence in the popularity of annuities.
When pension freedoms were introduced, annuity sales collapsed – by as much as 95%. Although they subsequently recovered to an extent, annuities remain a deeply unpopular product today. But although they’re still seen as delivering poor value for money, they nevertheless do what pensions are supposed to do – provide a guaranteed income for life.
Despite two Bank of England interest rate cuts over the last few months, average annuity rates have in fact risen over the past year or so. Annuity rates have improved by up to 50%. These improvements are still with us, and sales of annuities have gone up.
As one reason for income drawdown, the estate planning option, starts to disappear, could annuities be heading for a revival? That would certainly get DC pensions back to their original purpose.