Guaranteed premium whole of life policies
Whole of life policies have been a simple solution to traditional inheritance tax (IHT) for many years. They involve the IHT liability being covered by the amount of life cover secured by the policy. In effect, this means that the IHT liability is reduced to the total cost of the premiums. The life cover and the premiums can either be level or index-linked. The question has been asked as to whether such policies represent good value. Clearly the peace of mind the policy provides cannot be given an exact monetary value, however it often proves to be the greatest benefit. Nonetheless, we could look at this policy as an investment and try to work out the level of potential returns. This would help to determine whether it is ‘good value’ in pure monetary terms.
Guaranteed premium whole of life policies, although not treated as such, could be viewed as investments since there is a known annual premium and a known pay-out. The only unknown factor of course is the actual length of the premium payment period. One therefore has to make certain assumptions about life expectancy in order to have an idea of the total return being achieved on the premiums. The basic principle is that, with a fixed pay-out, the longer the payment period, the lower the return.
At the time of writing, the post-tax return currently available for a 45% rate taxpayer on a very long-dated UK government gilt (49 years to redemption) is currently only 0.872% per annum (which is for the most tax-efficient conventional gilt). couple aged 60 can obtain £1 million of ‘last survivor’ whole of life cover for an annual premium of £11,700 assuming standard health terms apply. If we were to assume that one of the policyholders lives to 109 (a very cautious assumption to match our 49 year gilt), the return on the total annual premiums of £573,300 is just under 2.2% per annum net of tax.
Continuing with this example we could assume, more realistically, that the life expectancy of the last survivor is 95. In our example scenario, the effective return on the total annual premiums of £409,500increases to a relatively attractive 4.73% per annum net. However, these figures also ignore the fact that the proceeds will generally fall outside of the estate due to the policies being held in trust. Therefore the actual return on the policy pay-out is effectively enhanced further (by 40% in most cases) by virtue of it being paid outside of the estate.
As a result, a 60 year old client who is happy to assume that a life expectancy age of 95 is a reasonable proposition, has the option of locking into over five times the current net return on the conventional gilt market by investing in one of these policies. This indicates such policies do represent a good value option for building up funds for the next generation or protecting the estate against taxation.
A final point to bear in mind of course is that the pay-out is only available on death – the policy, being a pure protection plan, does not build up a surrender value.
Defined benefit pensions and transfer opportunities
Defined benefit (or ‘final salary’) type pensions, which are the responsibility of the sponsoring employer, are often regarded as the most valuable type of pension arrangement as the scheme member receives a guaranteed retirement income without having to worry about the performance of the underlying investments. For most members of such schemes this position remains the same, however it is clear that there are now an increasing number of scheme members who are interested in looking at the option of transferring away from their defined benefit pensions.
Our view is that the main driver of this increased demand for transfer advice has been the changes in pension legislation, particularly those changes introduced in the last two years. Individuals can now access their pension funds with complete flexibility, and pension funds can be inherited by the next generation without an immediate tax charge. The combination of these two major changes has created widespread interest in exploring the option of taking transfer values from defined benefit pension schemes.
A further factor increasing the interest in transfers is the current level of interest rates. In general, a low interest rate environment may increase transfer values by lowering the discount rates used by Scheme Actuaries when they (transfer values) are calculated. (Think in terms of a larger capital sum being required to provide the same level of guaranteed income).
An important point to consider however is a higher transfer value is not always more favourable. The favourability relates to what is being given up, specifically the option of a guaranteed pension income. Not all schemes are created equally, some schemes also have favourable options attached such as guaranteed rates of increase both in deferral (pre-retirement) and in payment (post-retirement). The low interest rate environment, which has created the higher transfer value, should also be considered as there may not be an easy opportunity to generate good investment returns. It is worth noting that members of private sector pension schemes and funded public sector schemes have the right to transfer their benefits, yet members of unfunded public sector pension schemes do not have automatic transfer rights to transfer their benefits. Although most members of final salary pension schemes will favour the security of the guaranteed pension income, there may be individuals who have achieved financial security independently of their final salary scheme, who might look at the possibilities of a transfer to create a family asset.
It is always vital to seek financial advice before deciding to transfer from a defined benefit pension scheme, not least because of the many factors to take into account.
For example, the member’s attitude to investment risk, their ability to cope with fluctuations in the value of investments and their position with regard to the pension Lifetime Allowance. Giving up any level of guaranteed income is a very important decision, and once a transfer has been taken, the position cannot be reversed.