Techzone

The introduction of IHT on pensions from April 2027 has placed both estate planning and pension funding under the microscope. With income tax potentially payable on death benefits paid after age 75, concerns about continued funding are understandable – especially those who are funding solely as means of passing on wealth.

The government has initially forecasted that in tax year 2027/28, an additional 10,500 estates (1.5% of total UK deaths) will pay IHT as a result of this change, with 38,500 estates having an increased IHT bill.

However, for most of the population, concerns about IHT on pensions are likely overstated. Many people underestimate their longevity, the effects of inflation and the cost of retirement. Consequently, most individuals simply aren’t saving enough to fund their desired standard of living in retirement.

Life expectancy

When the Basic State Pension was introduced in 1948, the State Pension Age was 60 years for women and 65 years for men. The average life expectancy around this time was 66 for men and 71 for women, meaning a relatively short retirement.

Today, a 65-year-old male has an average life expectancy of 86 and a 1 in 4 chance of reaching 94. For females of the same age, life expectancy increases to age 89 with a 1 in 4 chance of reaching 96¹. Even those retiring at State Pension Age could still have two decades of retirement ahead of them to fund.

The cost of retirement

An independent report by the Pension and Lifetime Savings Association² (PLSA) released in February 2024 calculated what a single person and a couple would need each year to achieve a “minimum”, “moderate” and “comfortable” standard of living.

The full New State Pension is £11,973 a year in 2025/26, meaning there could be a significant shortfall for those retiring with little pension provision who want to enjoy their retirement.

It should also be noted that the figures quoted are after tax, so a single person targeting a “moderate” retirement would need gross income of nearly £36,000 a year. Assuming they retired at 65 and were entitled to the full New State Pension at 67, they would need a fund in the region of £600,000* to meet the “moderate” standard of living with their income increasing each year by 3%.

* Assumptions

• Investment growth of 3.5% net of charges
• Fund exhausted after 25 years
• £64,000 tax-free cash used to meet income in first two years

Long term care

Those who meet, or exceed, average life expectancy are also more likely to need care in later life, further increasing the costs of their final years. The research by PLSA does not include the potential costs of later life care and these could significantly increase the cost of retirement.

Current research³ indicates that the average cost of residential care in the UK is £1,266 a week, increasing to £1,554 a week for dementia nursing care. With life expectancy in care homes ranging from 2.2 years for males aged 90 and over, and 7 years for those aged 65-69⁴, costs could quickly reach six figure sums for those who must fund their own care.

Inflation

The cost of living will also increase year on year as inflation bites. The state pension increases with inflation, so do defined benefit pensions. Annuities can have escalation included but at an upfront cost. Drawdown income can be adjusted year-on-year to meet rising costs, but investment returns will dictate a sustainable level of withdrawal.

To put the effect of inflation in perspective, an individual who retired in 2015 with annual expenditure of £20,000 would need £27,218 today to maintain the same standard of living, assuming all of their costs had increased by CPI⁵.

This figure increases to £34,845 had they retired in 2005 and their £20,000 cost of living doubles to £40,509 had they retired in 1995.

Conclusion

With insufficient retirement savings, combined with rising life expectancy, the average retiree will almost certainly need to draw most, or all, of their pension to meet their living costs.

There is the possibility of clients dying at a relatively early age and IHT could be of concern if pension savings, when added to other assets, exceed their nil rate band. However, many individuals face a far greater risk of outliving their savings and any potential IHT liability may of course be met by taking out whole of life cover in trust.

Ultimately, these IHT changes will affect those high-net-worth individuals who have been saving into pension purely to cascade wealth through the generations. They may need to make adjustments to their financial plans in the future. For now, in the absence of the legislation, it would be prudent to hang fire on implementing any strategies until we know the detail.

For most people, the focus should be on taking stock on what standard of living their retirement savings will afford them and making plans to address any potential shortfall.

Robust, holistic advice and stress-tested financial forecasting will be essential in navigating the fine line between financial security and an inheritance tax liability.

¹ Life expectancy calculator.
² https://www.retirementlivingstandards.org.uk.
³ https://www.carehome.co.uk/advice/care-home-fees-and-costs-how-much-do-you-pay.
⁴ Life expectancy in care homes, England and Wales - Office for National Statistics.
⁵ https://www.bankofengland.co.uk/monetary-policy/inflation/inflation-calculator.