Treasury queasy at liberating pensions from inheritance tax

Government plans to abolish the rule forcing people to buy an annuity with their pension savings when they retire are good news - but they still demonstrate a curious hostility to those wishing to pass on assets when they die.

After all, the desire for greater control over pension savings was the over-riding objection felt by many towards the rule compelling them to annuitise by age 75.

Many people hated the fact that on retirement they were being forced to trap their pension savings into an annuity when they had no idea how long they would live. If they died soon after buying the annuity their money would be irrecoverable.

Instead they wanted to be able to pass on any remaining assets to their family when they died, and, when they were alive, the chance to generate a higher income than the paltry rates available from annuities in recent years.

Yesterday’s Treasury consultation paper leaves the door half open on the inheritance point. From next April individuals will not have to buy an annuity. Instead they can choose to drawdown an income direct from their pension savings: this income will be capped by an annual limit to reduce the risk of them running out of money and falling back on to state benefits (although there will be extra flexibility for people who can prove they have secured a minimum income elsewhere to take an uncapped income).

On death any unused funds will be will be hit by a recovery charge of around 55% - unless the assets are being used to provide a dependant’s pension. As Laith Khalaf of Hargreaves Lansdown tells Ian Cowie of the Daily Telegraph, this appears to assume that 25% of the pension savings were taken as a tax-free lump sum at retirement. Taking this into account this equates to a 40% rate on the entire pension pot pre-retirement: in other words the government is simply recovering the tax relief that the individual received on their contributions into their pension scheme. Fair enough.

The document explicitly states that ordinarily inheritance tax will not be applied on top of the recovery charge. However, it warns, ‘the government does not intend pensions to become a vehicle for the accumulation of capital sums for the purpose of inheritance.’ It says it will take action if it sees that people are suing pension savings to escape IHT.

So the Treasury appears to be saying, ‘you can avoid buying an annuity and you can pass on any remaining pension savings on your death to your estate but leave too much and we’ll get cross.’

Perhaps that is justified. If it is, it means the chief attraction of the reforms is generating a higher income than you would get from an annuity. Here, we get into much trickier water because past experience shows that operating a pension portfolio in drawdown is extraordinarily difficult. The money has to be invested in such a way that it will generate an income while suffering a minimum of capital losses. Unfortunately, many retirees who postponed buying an annuity this decade saw their pension pot smashed to bits in the stock market crash. For those in the early years of their retirement it is unlikely they will ever recover their incomes to the level they would have got from an annuity.

The unpalatable truth is that for most people with modest savings an annuity is the best bet. Annuity rates may be low but the income they generate is guaranteed, unlike the income from an unsecured pension pot. As always, freedom comes at a price.