When building your retirement nest egg, it is a good idea to check out all the different options that are available to help you accumulate funds and ensure you obtain the very best for your future, says Rachel Vahey
No-one wants to get to retirement empty-handed, particularly these days, when the period spent in retirement could be 30 years or more, and when the Government is trying to lessen the role the State plays in providing pension benefits. However, one of the bits of good news about UK long-term savings is that today, more of us than ever before are likely to have a choice of ways to generate cash streams in retirement.
There are a number of different ways of accumulating funds for retirement. These include regular contributions into a personal or occupational pension, investments in property - including second homes and buy-to-lets - Isas, investment bonds, shares and so on.
Prudently invested, UK pensions still offer one of the best rates of return of any investment. After all, higher-rate taxpayers currently get 40% added to their pension contribution by HMRC. Moreover, in a work-based pension fund where the employer contributes to the employee fund, that contribution equates to 'free money'.
For many people, one of the best solutions to the challenge of funding a long retirement is an annuity. The reason is simple. An annuity pays an agreed income for the whole of a person's life, irrespective of how long they live. The downside, of course, is that buying an annuity is a one-way street with no going back on the decision, the risk of inflation devaluing your income and limited opportunity to pass on money to dependants on death.
Many people are wary of pensions because they associate them with the obligation to buy an annuity. They would rather invest in a plan where they can still get hold of their money if they want or need to.
One alternative retirement solution now available to people wanting to invest for income in retirement is the so-called 'variable annuity', or 'third way' product. Whatever the name, generally they all aim to achieve the same thing. In return for an initial investment, these plans provide a guaranteed income stream for life while still allowing the investor some control over where their fund is invested. They provide a combination of certainty and control that was not available in the UK until recently.
These products exist in both the investment market and the pensions market. Although they have been dubbed 'variable annuities', for the pensionable products of this kind, we prefer the term 'guaranteed drawdown' - however, for the purposes of this article, we will only look at the investment third-way products.
With a third-way product that is outside the pension system (meaning, where there are no tax breaks on the lump sum invested), the individual can have access to their investment should they require it and, as with an annuity, they are guaranteed a minimum return each year for life.
Income from a third-way product is broadly comparable to that of a standard annuity. A typical sum offered by third-way providers is 5% of the capital a year.
A strong plus point for these new retirement solutions is that much of the money paid back as income to the investor is treated as a repayment of capital and is therefore tax-free. The interest component will be taxable at the investor's normal tax rate.
Another key point here is that although for tax purposes the income component is treated as a return of capital, the agreement between the provider and the investor is for life. Even if the investor takes the whole of the original sum as 'income' (return of capital) and depletes the fund entirely, the guaranteed benefit payment continues for life.
With any investment, one of the most important factors to take into account is the intentions of the investor. For some investors concerned about their inheritance tax (IHT) exposure, the idea of passing a stake on to the next generation may rank up there along with the necessity for securing retirement income.
With the IHT nil-rate band for individuals currently at £312,000, for estates over this, the idea of paying IHT at 40% is a real concern. However, it is often the case that the investor does not wish to hand large amounts of money to children or grandchildren, and thus lose control of the capital. Remember that we are talking now about the options facing investors who have one-off lump sums to invest, rather than about regular monthly contributions to a pension.
Types of trusts
This is where trusts have an important role, not only in being able to reduce an individual's potential IHT liability, but also providing comfort to the individual that if they choose to be a trustee, they will not necessarily lose control of the underlying capital.
We are finding that a popular choice for investors is life bonds, which are commonly used with trust mechanisms to meet investors' needs.
There are two main types of trust for investors to consider - either a bare or discretionary trust. A key difference between a bare trust and a discretionary trust is that the discretionary trust gives the settlor (the individual who is providing the lump sum) flexibility to change the beneficiary after the trust is set up. A bare trust does not. Any beneficiary named in the bare trust is there for good; their share of the trust cannot be altered.
A trust that is set up using a life office investment bond will usually make use of the life office's prepared trust deeds, which are easily available and usually at no additional cost. Most life offices offer bare and discretionary trusts with three variations: either a gift trust, discounted gift trust or loan trust. We will look at when you may wish to use these later.
The value of the gift in a bare gift trust is potentially free of IHT if the settlor survives for seven years after setting up the trust. Also, bare trusts are not subject to the discretionary trust IHT regime; there is no 20% IHT charge on exit, nor does the trust have to pay 6% IHT every 10 years. The growth of the value in both bare trusts and discretionary trusts is free of IHT for the settlor.
So why do people use discretionary trusts? The big disadvantage of a bare trust is that beneficiaries have an absolute right to their share of the trust on achieving their 18th birthday. With a discretionary trust, the trustees determine who can benefit from the trust fund and when, and with it being possible for the settlor to be a trustee, we are finding this becoming a popular option with these investors.
The discounted discretionary or bare trust is another option for an investor who wishes to undertake IHT planning, but may still need an income from the capital. It is offered by most life offices. The main benefit is that it can provide an immediate IHT saving once the settlor has been underwritten; if the settlor survives seven years, like a normal bare or discretionary trust, the total value is removed from their estate for IHT purposes. In addition, these trusts provide an income to the settlor in a tax-efficient manner.
It is important to realise that both bare trusts and discretionary gift trusts forever distance the money from the settlor, and they are not suitable if there is a chance the settlor might need access to the money at some future date.
This is where the loan trust could be useful. With a loan trust, you lend the trustees, say, £300,000. This is not a gift, so from an IHT point of view, it does not matter if you die in the next seven years. If you need access to the money, you simply ask for it; alternatively, it is possible to write off parts of the loan, reducing your IHT estate. When you die, IHT is paid on the outstanding loan, but all the growth is IHT-free.
In effect, the loan trust is an IHT capping exercise, reducing the amount value of your estate, but providing access to the original capital.
There are many possible avenues open to people thinking about retirement income. Independent financial advisers have much to offer in this area, and providers are always keen to work with IFAs to ensure they understand the full range of possibilities available to them in any planning exercise.
- Rachel Vahey is head of pensions development at Aegon.
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