Whether by accident, design or inertia, the tax treatment of pension pots at death has – in the age of pension freedoms – become increasingly anomalous. With the amount of wealth held in defined contribution pensions increasing year-on-year, and with well-understood incentives for those who can afford it to ‘stuff your pension full of cash – but don’t spend it’, this is a problem that will only get worse. Without reform, pensions will increasingly come to serve not just as a means of funding retirement, but also as a vehicle for the wealthiest households to reduce their inheritance tax liability.
A sensible set of reforms would include pension pots in the value of estates for the purposes of inheritance tax and extend current income tax practice for those who die aged 75 and over to those who die at any age. This would leave the tax system both fairer and more economically efficient.
It is not yet too late to act, but the longer the government delays, the more painful such reforms will become. The Chancellor has a great deal on his plate, but failure to embrace reform now will leave a legacy for which his successors will not thank him.
There are very real consequences of this reform and they all come back to there being too many pension pots and not enough pensions. Though John Ralfe and I have different views on how you turn pots into a wage for life solution, I agree with John’s position on this that has held firm since he first spotted the anomaly in 2014 and wrote to the FT about it,
The IFS calculate the tax loss at rather less than £10bn , and the tax loss reduces the more money is drawn-down from pots.
Short-term revenue would be limited because few of those dying today are bequeathing pension pots. But if the generation benefiting from pension freedoms – those retiring after April 2015 – were to die with their full pension pots intact, we estimate that it would raise the equivalent of £1.9 billion a year (in today’s terms) in extra inheritance tax revenue. This increase would be substantial, representing an increase of around a quarter in the scope and yield of inheritance tax. The yield is very sensitive to the extent to which pensions will be run down before death: were half of current pensions intact at death, the yield would fall to £0.9 billion.
There are other economic factors at work here. It is not just the wealthy who are not drawing on their pots, the majority of pots being drawn are being cashed out, it is thought by people who don’t pay much tax , but of those using flexi-drawdown, UFPLS and buying annuities, represent less than those over state pension age who could be turning pots to pensions.
There appear to be a hinterland of savers who find it hard to become spenders and who seem to be waiting for an attractive pension offer to come along. This might happen if annuities got really cheap or it might happen if CDC as a retail product takes off , but it looks unlikely to happen if the status quo is maintained.
Death benefits are important
I know , from giving advice and guidance to people at least half-way through their lives, that people prioritise leaving money to their heirs over spending money on themselves and this bias is the same in the UK , Australia, Canada – anywhere you look where the option to roll-over cash on death, is permitted.
So not taxing personal pots till 75 is a popular policy and enhances the pension freedoms. But it prevents innovation around drawdown, CDC and the popularity of annuities.
The proposals put forward by the IPS , assume that the proper deployment of money saved for retirement is 25% cash and 75% pensions and that tax-policy should be aligned with the incentives to get people into this position. It points out that the tax incentives lead to financially literate people , drawing down from non-pension assets and leaving the pensions alone (which accounts for so much money saved by “pensioners” is washing around in the wealth management eco-system or unclaimed from workplace pensions , rather than having been converted to some kind of wage for life.
Until this tax anomaly is addressed, there is little incentive for advisers or providers to change their current practices and adopt a more proactive approach to nudging savers into pensions. If you can make 0.75% (or a lot more) by leaving money to roll up, what is the commercial imperative to get people to spend their pots? Why not get them to take out a lifetime mortgage instead, or downsize , or live off an inheritance?
If the Government is looking to Australia for inspiration, it can see that the Australian Treasury and Regulator is making major interventions to get people to spend their Super pots via wage for life income streams. Everything points to the UK Government having to do the same, and the most painless way of doing that is by abolishing a loophole, increasing tax-revenues and encouraging an insurance against living too long.
The X-factor is long term care
One final point; we have yet to see consensus behind how we fund long-term care. The pension pots that are left unspent can become part of the solution.
We need to remind people, that money kept in pensions isn’t entirely out of the grasp of the state, any justification for removing the personal pension tax loop-hole , should include a reminder that for most people, the pot is likely to run out before they do.
Organising the orderly payment of pensions from pots should remain the top priority. Removing tax incentives to keep money in pots, is a step towards that larger goal.