Recent Changes Impacting Pension Drawdown
In the last two years there have been two developments likely to have a big impact on how we execute pension drawdown in the future.
- The introduction of pension accounts into the inheritance tax (IHT) net
- The increase in bond yields now producing strong real returns above inflation
On Bond Yields
We are finally seeing real returns (ahead of inflation) from bonds again. This allows an alternative, lower risk, investment approach to protecting the value of funds from inflation, rather than relying on more volatile equity, or share-based investing.
In the aftermath of the Great Financial Crisis of 2008/9, governments around the world use quantitative easing (QE) to depress bond yields and support the economy. Yields got so low that much of the bond market was offering returns less than inflation, especially after investing costs. QE was used again during the Covid crisis, but abruptly stopped and put into reverse in 2022 as inflation took off.
Yields on bonds have now returned to their more expected level and offer a return rate well above inflation again, even after costs. The artificially low bond yields of 2010–2022 encouraged investors to take more risk and put more of their investments into the stock market and into shares, or equities are they are known. In pension accounts that allow for tax free reinvestment, we can now protect our pension money from inflation, until such time as we want to withdraw it, in much less volatile and lower risk investments.
On Inheritance Tax
Whilst the change to bring pensions into inheritance tax is not due until April 2027, it seems prudent to stop thinking about pension accounts as intergenerational investment plans but rather as solely a means to generate income when our earned income stops.
“This will restore the principle that pensions should not be a vehicle for the accumulation of capital sums for the purposes of inheritance, as was the case prior to the 2015 pensions reforms.”
Government statement after the November 2024 Budget.
Whilst the detail may change, given the need of any future Government to raise taxes, we think it’s sensible not to expect a full reversal on this principle.
Previously, pension accounts could be passed on tax free to the next generation and were not included in estate calculations to work out inheritance tax. This meant they could be at the bottom of the list of accounts to access to create the income we need after work and we could be relaxed about excess funds building up in pension accounts.
If there were funds left over at the end, or indeed we did not need the pension income ourselves, the accounts could continue to grow tax free and were a convenient and tax efficient means of passing funds to future generations.
This was turned on its head in the November 2024 Budget, which has placed pensions towards to the top of the list of accounts to access when IHT is considered. By making pension accounts subject to inheritance tax, part of the estate calculation, and still subject to income tax on withdrawals, they have become significantly less tax efficient to pass on.
Given the relatively low tax thresholds (£1m of inheritance tax and c.£50,000 per year for 40% income) it is easy to see how, without any mitigating action, large numbers of families could end up paying 64% (40% twice) on the value of pension accounts as they are passed down through the family.
Tax Tip
Getting estate values below £2m is very tax efficient.
Estates below £2million in value enjoy both nil rate inheritance tax bands of £325,000 (or £650,000 for a couple) and a main residence allowance on top of £175,000 per person (£350,000 for a couple), so the first £1million is passed tax free.
Example 1
The beneficiaries of an estate worth £1.8million, where at least £350,000 was the value of the main residence, would pay inheritance tax of £320,000 – an effective rate of just under 18% on the entire estate.
Example 2
As estate values go over £2million, the estate loses the main residence allowance. The allowance is lost at the rate of £1 for every £2 over £2million. This greatly increases the marginal rate of inheritance tax paid.
Mitigating Action
The way to mitigate the double tax treatment of pensions will be to aim to exhaust the pension accounts before death, or if you are a couple, before the last death (as pension funds can still pass between spouses free of inheritance tax).
Some would consider buying an annuity as a way to do this, and as bond yields have increased, so have annuity payouts – however, annuities remain expensive relative to newly available bond returns.
If you are on track to have full state pensions and an estate big enough to attract a significant amount of inheritance tax in your late 80s, let’s say an estate of more than £2m, then its likely you won’t need to buy an annuity to insure against running out of money. This will be true even if you end up living beyond normal life expectancy. In effect, you don’t need to pay for insurance against living a long life, as you have enough money to hold your own risk. I have written a paper on this if you want to understand this more: ‘Why I Will Never (Personally) Buy an Annuity’.
Alternatively, you need a fresh approach to drawdown. This will be to exhaust the pension fund before death and the good news here, as we will see further on, is that this will produce substantially more income in your 60s and 70s than is available from annuities. It goes without saying that this will need careful planning to execute and to ensure you still have later life financial security after the pension funds have gone.
Recognising that exhausting your pension fund may be your best option, the next big questions will be:
- How quickly should we run our pensions down?
- How much should we be drawing to run them down?
- Do we need to invest differently if we are going to take this approach?
- How much tax will I need to pay to exhaust my fund?
- How do we ensure later life financial security if we have no pensions left?
- What should we do with the funds we don’t need if this plan results in more income than we need?
1. How quickly should we exhaust our pension accounts?
After the tax relief on contributions and the tax-free cash sum, being able to invest largely tax free within your pension account is a big tax break – it makes sense to enjoy this for as long as possible. But this now must be weighed up against the tax in efficiency on having a pension account in your estate on death.
The answer for most people will be to aim for your mid-80s which is now average life expectancy. If you already have a life-threatening illness, or if you have particularly good genes in the family history, you may want to exhaust your pension accounts a little quicker or hold on to them a little longer. But, generally speaking, age 85 (or 85 for the youngest in the couple) is a good target.
Life expectancy for a 60 year old woman according to the Office of National Statistics
It is also a good age to consider lifestyle spending needs. Lifestyle spending is spending above the basic amenities of heat, light, water, and food. If you have a mortgage-free home, most of these basic income needs will be covered by the state pension, which gets fully linked to inflation every year.
Lifestyle spending is more about what we do with our spare time and how much we spend doing that, which varies a lot from person to person. What appears to be common is that lifestyle spending seems to drop off for most people towards the end of their 80s, (sooner for some, later for others). In general, our lifestyles beyond these ages tend to quieten down and get cheaper.
There are, of course, medical and care costs to consider for later life. Some of these may be regular costs, some might be one off, but if your estate is still worth around £2m by your mid-80s, the chances are you have more than enough to deal with these later life costs.
2. How much will I need to withdraw to exhaust my pension fund?
To exhaust a pension fund by age 85, you will need to take significantly higher withdrawal rates to those we have been used to recommending. Most advisers have historically recommended withdrawal rates of c.4% a year, considered to be a ‘safe’ and sustainable withdrawal rate so as not to run out of money.
However, if your objective is to run down the pension fund, these rates will need to be increased substantially. Below are the level and escalating drawdown rates you would need to use to exhaust your account by age 85, depending on starting age. These assume a 6% p.a. return on your pension drawdown account (after costs). They are compared to current annuity rates from a leading annuity broker at the time of writing (February 2025).
These starting drawdown rates are all higher than the current perceived ‘safe’ withdrawal rates and will require a different investment plan to deliver them.
3. Do we need to invest differently if we are going to take this approach?
The short answer is most definitely yes.
A few issues come into play if you are going to plan to exhaust your pension by your mid 80s:
- Your general investment time horizons start to shrink. With shorter time horizons comes less opportunity of earning a premium return from equities.
- The withdrawal rates can’t be supported by the natural income yield on your pension investment portfolio. To run down the account value you will have to cash in capital each year as well as withdraw income. This in turn means that some of your capital is only going to be invested for a handful of years, over which time frame equities become a lot more risky.
- The need to cash capital must be managed to avoid selling equity-based investments after equity market corrections. Without a management process in place to address this, your returns from investing in equities will be lower than those not drawing an income, or indeed reinvesting dividends. This is known as sequencing risk, which we have written about here.
The good news is that with much higher bond yields you can reduce risk by investing more of your account in bonds rather than equities. Tideway’s Dual Account drawdown solution can also be used to address the sequencing risk issue.
As ever, the way to address the investment challenge is to start with a good plan. Your adviser can help you build a cash flow model which will help you agree how much to have in bonds versus equities and the two separate accounts.
4. How much tax will we have to pay to exhaust our pension accounts?
Let’s look at the tax cost of stripping down pensions – this is probably not as bad as you think.
Below is the tax you will pay on your total pension income in any one year, assuming you can arrange your investment affairs to have no other taxable investment income (which, for most couples and individuals, is very doable).
Therefore, if you:
- received 40% tax relief to build up the pension (or your employer mostly made up the contributions);
- enjoyed tax free investment growth for many years;
- have had a tax-free sum
then even stripping pensions up to £250,000 in one year will still result in total tax less than 40% and lower than the IHT rate.
Tax Tip
For those where the withdrawal rate combined with the pension value shows an income between say £100,000 and £150,000 it will be more tax efficient to draw varying amounts, keeping withdrawals and total stable income to under £100,000 most years and then occasionally making a bigger withdrawal to lower the account value.
This is due to the 60% death tax rate that applies above £100,000 a year of income where you start to lose your nil rate tax band. Your adviser will be able to show you the potential tax saved by this approach.
5. How do we ensure later life financial security if we have no pensions left?
Fortunately, pensions aren’t the only way to create financial security beyond age 85. How this is done will depend on the form of your estate and how liquid it is.
If there is a balance of liquid investments and property, you will be able to spend those other savings first. If planning has been done these, might be in Individual Savings Accounts (ISAs) and will therefore be accessible tax free.
Once all liquid assets have been exhausted, an ‘equity release’ loan on your home could then be a solution.
This may all sound a little scary, but if you still have £2m or more in your estate then spending down the capital further will be very tax efficient. As can be seen in the earlier examples, spending the additional £1,000,000 of capital in Example 2 before you die would only cost your beneficiaries £460,000 after tax!
6. What should we do with the funds we don’t need if this plan results in more income than we need?
This will be a key discussion point with your adviser. First and foremost, you need to make sure you have sufficient savings and capital to look after yourself for the rest of your life or lives, factoring what later life care and medical costs you might expect.
So, this may mean that some of the excess income you create may need to be reinvested in an ISA or an offshore bond for your use later in your life. Both of these accounts, like pension accounts offer tax free reinvestment within the account. ISAs are tax free on withdrawal, offshore bonds are taxed on withdrawal but careful planning with a family can mitigate the amount of tax payable.
Once your lifetime financial needs are secure, the way to mitigate your beneficiaries’ inheritance tax bill will be to give them the funds whilst you are alive.
In the case of surplus pension income, it should be possible to document this as ‘gifts from income’, which immediately fall outside of your estate. This takes the pressure off needing to do it seven years ahead of death to avoid inheritance tax, as is the case with a ‘potentially exempt gift’.
Putting all this into practice
Here is an example of collapsing a large SIPP (self-invested personal pension) valued at £1.8m over 20 years, where none of the income is required and reinvesting the net income into alternative tax efficient accounts (either ISAs or Offshore Bonds). See Appendix 1 for the assumptions made and key risks.
Shifting Funds From Larger SIPPs to Alternative Exempt Investment Accounts Over 20 Years
- It keeps withdrawals to £100,000 per year for most years and then every few years takes a big withdrawal, to avoid regularly incurring the effective 60% tax band above £100,000. This drops the income tax paid overall by around 1% compared to taking smoother withdrawals, saving approximately £24,000 in today’s money over the 20-year plan.
- It uses a higher-risk higher-growth strategy for the reinvestment into the new tax efficient investment account, as compared to a more conservative approach to investing the SIPP with the larger withdrawals. This higher return, if achieved, would add around £250,000 in today’s money terms to the new accounts compared to investing completely on a more cautious basis.
- Most importantly, if it becomes clear you do not need the money in the new accounts, it will be possible to gift these funds to the next generation to avoid inheritance tax. If saved in ISAs or planned well with an offshore bond, these funds would either avoid or reduce further income tax. The saving here, compared to simply rolling up the pension fund and paying the IHT and income tax as outlined in last year’s Budget, could be in the region of £750,000 in today’s money terms.
Conclusions
The key takeaways from this are:
- It looks sensible not to rely on pensions as a tax efficient means to transfer funds to the next generation
- As soon as its either no longer possible to contribute to your pension or it’s large enough that it is no longer tax efficient to contribute further, then it may make sense to consider reversing the process and stripping down the pension fund whilst you are alive – even if you don’t need the money
- Excess funds from this process can either be gifted to avoid inheritance or reinvested in alternative tax-efficient savings accounts to maintain your financial security, but with the option of lifetime gifts later in life.
- Spreading your savings out into other accounts like ISAs and offshore bonds will give you more flexibility in later life and more options to reduce taxes.
- Getting good advice and collaborating with the next generation where appropriate will help you:
a. Lower the tax on your pension withdrawals
b. Earn the best returns on your accumulated funds from lower volatility assets that won’t be impacted by larger withdrawals
c. Invest any surplus funds as tax efficiently as possible within the family, without putting your financial security a risk.
Please do get in touch with a Tideway adviser to discuss any of the issues and planning solutions raised in this paper.
Appendix 1
Key assumptions
- The example assumes a 3% real return after fees on the SIPP account and a 4% real return after fees on the ISA and Offshore Bond accounts.
- It assumes a flat rate of tax of 30% on pension withdrawals up to £100,000 and a flat rate of 40% tax on higher with ad hoc withdrawals in this case £250,000 every four years up to an including age 70.
- For the saving highlighted in point 3 it assumes all the non- pension account funds are passed to the next generation before death and therefore avoid IHT using the current potentially exempt gift rules and gifts out of income for the later years.
- It assumes deferred tax liabilities in any offshore bond can be largely mitigated after any gift, investments in ISAs can be cashed in tax free before gifting.
Key risks
- The return for the new tax-efficient accounts is not achieved by taking a higher risk strategy, this risk would be mitigated by the regular investment over time used in this example which would provide pound cost averaging on reinvestment
- It assumes tax rates and tax treatment of gifts, ISAs and Offshore Bonds remain largely in line with current tax rules and that tax bands are moved in line with inflation in future, which has not happened in recent years but is expected to be re-introduced from April 2029.
