HMRC plays the ageism card on IHT planning

The value of a gift for Inheritance Tax purposes is calculated not by reference to the value of what you have given away but by reference to the diminution of your estate as a result of making the gift.  This subtlety avoids evasion by making small gifts which dramatically reduce the value of one’s estate – for instance by gifting away a minor 5% shareholding which removes voting control from the donor!

 In the case of a traditional discounted gift trust the value of the gift into trust is discounted by the value of benefits retained by the donor.  So if a taxpayer gives away a £200,000 investment (normally an investment bond but in some cases unit trusts) but ‘carves out’ and retains an annual reversion of 5% or £10,000 per annum, then the value of the gift is £200,000 less the value of the retained ‘income’ rights.  The value of those rights at the point of making the gift obviously depends on how long the donor is likely to live and on assumptions about interest and inflation rates.  If the donor is likely to live 20 years (and will therefore likely receive a return of £200,000 over that period) then the discount will be very large.  The older the donor is at the time of making the gift the lower the discount will be.

 This process and valuation model is totally logical and actually reflects the accepted means of calculating the discount on such mitigation schemes.  In spite of this generally practical approach to discount valuation the technical definition is somewhat different and is enshrined in Section 160 of the Inheritance Act 1984, which puts an ‘open market value’ on any rights carved out and retained by a donor in such schemes.  Since an open market value is largely a theoretical concept – donors never actually wish to sell their ‘income’ rights – HMRC are happy to rely on the actuarial model described above.  So happy are they that they have spelt out, in guidance notes, precisely how the calculations should be made and what mortality tables should be used.

 The problem with the elderly has arisen over the last 5 years or so since when the HMRC has imposed its own interpretation of what constitutes an open market value.  They have been claiming that no discount is applicable to elderly donors because no potential open market purchaser would be able to ‘insure’ against the failure or potential loss resulting from their purchase, by taking life cover on the donor’s life (due to lack of demand there are very few opportunities to insure the lives of those aged 90 and over).  They suggest that an inability to insure means that the rights would have a nil open market value – they would be unsaleable.

 Last year a case went before the Special Commissioner because HMRC had once again disallowed an actuarial discount to a lady of 90 who had invested in just such a scheme and died several months later.  The challenge to HMRC had been sponsored by AXA Isle of Man whose scheme was involved.  There was a collective, albeit premature, sigh of relief in February following publication of a ruling by the Special Commissioner granting a compromise discount to the donor.

 On 7th February 2008 Special Commissioner, Howard Nowlan, ruled that the derisory £250 nominal discount offered by HMRC to an elderly DGT client was unreasonable. The case, the evidence presented and the ruling were all extremely important for those of us working within Inheritance Tax mitigation. 

For me the crunch here is that the legislation talks of ‘open market value’ but makes no reference to insurability.  The HMRC have been relying on standard practice of specialists like Foster & Cranfield who deal with the valuation and sale of second hand annuities and insurance policies.  Commissioner Nowlan, I am pleased to say, approached the whole issue from a more common sense perspective and noted that regardless of her potential insurability, or otherwise, there would be plenty of theoretical investors who would be prepared to take a ‘punt’ on her life at the right price – including himself!  To suggest that the lady’s retained lifetime ‘income’ stream could be valued at the final and derisory HMRC offer of £250 when that ‘income’ stream yielded a net return of £304.16 per month was nonsense.  She would only have to live for a month for the purchaser to be left in profit and whilst she was certainly of impaired health she could reasonably have been expected to live at least one month!  He did comment that a 90 year old in normal health would be expected to have a substantial life expectancy and a much larger discount would therefore be appropriate.

 It has now been reported that HMRC is still not content to accept the Special Commissioner’s compromise discount value and plans to appeal.  This is disappointing but not necessarily a surprise.  Mr Nowlan actually came up with a somewhat ‘Heath Robinson’ approach to valuing the discount which involved taking two thirds of the calculated actuarial discount and then deducting likely expenses of £1,000!  I think all of us would have preferred a straightforward acceptance of the practical and traditional approach used for those under the age of 90 and which was generally accepted until a few years ago.  Anything else amounts to ageism in its meanest form.  The graph shows a typical level of discount applicable at different ages and indicates that whilst discounts will gradually reduce with age there is no justification whatsoever for them to ‘fall off a cliff’ to nil at age 90 just because HMRC wish to arbitrarily hit those least able to defend themselves.  How can income or withdrawal rights be very valuable one week before attaining the age of 90 and have no value one week later!

 We await the appeal process with interest and hope that reason will prevail.

 In the meantime it was usefully stated in the judgement from Mr Nowlan that “it was accepted by HMRC that the 5% annual withdrawals under the policy, these being the sole entitlement of Mrs. Bower under the Trust, would be tax free and would occasion no liability for higher rate tax as “chargeable events” under the Income Tax provisions relating to insurance policies. It was also accepted that as Mrs. Bower’s rights were clearly defined, there would be no question of her being treated as having made a gift with reservation of benefit for Inheritance Tax purposes such that the whole gift would be disregarded. It was also accepted that she was not to be treated as having a life interest in the whole of the settlement and treated as owning all the settled property for Inheritance Tax purposes”.  Pre-owned asset tax would therefore also not apply. 

 In essence we have been delivered a watertight judgement about the general efficacy of Discounted Gift Schemes even if we temporarily remain in disputed territory for older clients entering such schemes.

Mark Benson,
Technical Manager, WAY Group.

Posted on 20th April, 2008 |
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Multi-manager a.k.a. unitised portfolio funds

The concept of collective investment has been around for almost a century.  Unit trust companies like M&G and Save & Prosper were pooling investor funds and investing with the benefits of economies of scale from the 1930s onwards.  The principle of collecting together investors’ moneys and then appointing a specialist stockpicker to run a large and effective fund of invested shares became very popular with the more sophisticated investing public.  Instead of having an individual portfolio which needed regular attention, large amounts of administration, including the completion of annual tax returns, and the potential for regular tax liabilities every time profits were taken, investors could suddenly buy and enjoy owning a collective fund.  The benefits were not limited simply to convenience or to putting off any tax liabilities.  The primary benefits were the ability to achieve much greater diversification than would be possible with one’s own limited portfolio and the opportunity to share in the rewards of employing a top class manager and his or her 24/7 team rather than simply your tired local stockbroker.

 In those early days investment tended to be limited to the UK market where many international companies were, in any case, listed.  As exchange controls disappeared (as late as 1979 in the UK when Margaret Thatcher opened up the markets) it then became more conventional to have some exposure to overseas companies within your mainly-UK portfolio.  It was in the ensuing decade, the 1980s, when overseas unit trusts really took off.  Specialist funds based on various markets around the world, both large and small, managed by specialist managers who were often based in those geographical areas, flourished during this time.  I recall funds investing specifically in Hong Kong, or Singapore and Malaysia becoming very popular.  During this phase your local friendly stockbroker would have progressed to setting up client portfolios, mainly comprising a range of UK blue chip shares, supplemented by two or three holdings in specialist overseas unit trusts.

 In my own case as a Licensed Dealer in Securities, back in the dim and distant early eighties, I became manager of a range of third party insurance funds.  In my view funds like these were in the vanguard of the Multi-Manager movement.  Regulation then was not even a twinkle in the Government’s eye and yet most of us were highly professional both in our motives for establishing such funds and in the way they were managed.  It was an opportunity to set up a pooled fund of investors’ money and then to invest and manage it across the world, utilising the combined skills of all the top specialist managers and funds available.  Many of those early funds (subsequently dubbed ‘broker bond funds’) were pretty effective for their unitholders.  In those early days the life companies tended to be scrupulous in their vetting of the competencies of anyone wishing to set themselves up as managers of such funds. Generally anyone appointed was extremely talented and professional.

 Unfortunately the success of such funds was their undoing.  They had generally turned in competitive performances during those early years and were attracting increasing amounts of money.  Not only that they gave advisers the opportunity to collect their clients’ assets into a more easily managed format – one which offered not only a greater sense of corporate ownership but a regular management income deducted at source and paid over by the life company.  Soon a number of commercially successful advisers, but with far less adequate skills and experience, were set up with these broker bond funds.  To compensate for their lack of skill certain insurance companies invented ways for such managers to ‘milk’ the system by indulging in historically priced switching – betting on certainties.  Of course any such benefits were always at the expense of the other unitholders in those underlying funds who suffered the cost of such historic dealing.  By this time the new Financial Services Act was in force and it was not long before broker bond funds were under the microscope.

 As one door closes another one generally opens.  Whilst the broker bond saga was brewing the more purist investment industry, comprising the unit trust companies, was developing funds which were not invested in shares but instead across a range of other specialist unit trusts – the fund of funds unit trust was born.  Initially such funds were only permitted to buy underlying funds on a charge-free basis in an attempt to avoid double-charging.  Fortunately it was not long before rule changes were introduced into the administration of such trusts whereby fund of funds unit trusts were permitted to buy underlying funds at ‘best’ rather than at cost.  This was October 1991.  Being the unit trust industry this development was seen as offering a more comprehensive means of accessing specialised markets rather than as a potential panacea for portfolio investors.

 For us portfolio-style managers, however, it offered an even more effective means of delivering collective portfolio management than was available from the old broker bond funds.  The costs were lower and the potential tax savings were even greater.  Firms like Old Mutual and what subsequently became Capita, started offering their unit trust administration structures to third parties who wished to manage their various clients portfolios on a more efficient, contemporary and effective basis.  Firms like WAY have come in later offering even more specialised services whereby third party managers can access sophisticated financial planning structures underpinned with their own funds and/or fund management.

 Recent bear markets and the associated volatility within funds and markets have continued to highlight the benefits of Multi-Manager style investment in the hands of competent and independent managers.  More recent changes in fund rules permitting greater mixing of asset classes has improved the scene even more, allowing the professional Multi-Manager to utilise all the important funds, managers, assets, asset classes and financial instruments to generate competitive returns with low volatility.  We must not allow this success to be the undoing of the new breed of third party MultiManagers just as we did with broker bond funds.

 In reality TCF dictates that we all manage our clients’ assets in the most effective and fair manner possible.  So long as MultiManager funds are established with very clear investment mandates and are managed appropriately by fully-qualified and top-class managers they will go from strength to strength.  Long live the MultiManager Fund!

Paul Wilcox,
Chairman & Technical Director, WAY Group.

Note: WAY Fund Managers has recently launched a new Multi-Manager fund, the WAY MA Growth Portfolio, managed by T. Bailey Asset Management.  WAY Fund Managers also acts as host ACD to several third party unit trusts under the Elite banner.

Posted on 1st April, 2008 |
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Pernicious tax hits surplus pension funds

For many years there was a persistent clamour from the financial community and from aging pensioners for the Government to change the rule that made the purchase of an annuity compulsory for 75 year olds with non-vested pension funds.  This was because pensioners wished to keep their funds intact for their beneficiaries to inherit when they finally departed this mortal coil rather than pay out the accumulated fund in exchange for what was often a surplus and highly-taxed income.  Similar funds for those departing before age 75 had been available for payment to beneficiaries free of Inheritance Tax (IHT) and with increasing life expectancies it was becoming obvious that compulsory annuities at this increasingly young age were a problem.

 Gordon Brown came up with a great solution – the Alternatively Secured Pension or ASP.  This was launched in April 2006 having been mooted as long ago as 2003.  It allegedly came about as a result of the Plymouth Brethren objecting to being forced into ‘gambling’ on life expectation – which is how they view annuities.  Gordon Brown took due notice of their concerns and introduced ASPs aimed at those with principled religious objections to annuities. 

 As he has subsequently pointed out many times, they were never intended as a means for wealthy people to pass on tax-advantaged savings to dependents.  In other words, although residual pension funds left by pensioners dying before age 75 can be passed to beneficiaries, he is determined that those living beyond that arbitrary age should be committed to either taking an annuity or losing their funds to the tax man!  This is why he launched the concept in April 2006 and effectively knocked it on the head again in December 2006 by imposing a tax and penalty charge of up to 82% on residual funds!

 So in effect we are back to taking our pensions by some means or another before age 75 and finding an alternative route to diverting them to our families in the most tax-effective manner possible.  This is particularly the case for all those post-war baby boomers who have acquired non-pension assets well in excess of their likely lifetime needs in addition to healthy and ‘surplus’ pension funds.

Is there an alternative means of dealing with a surplus pension fund of £1 million which can both:
           a)      Allow beneficiaries to receive more than the derisory 18% on offer if it goes into ASP?
           b)      Avoid the compulsory income accumulating in the individual’s estate and thus inflating their IHT liabilities?

 The simple answer is yes, and how some!  Although the saver does not need the money the sensible approach is to take the maximum tax free lump sum (of 25%) early on in the process.  On £1 million this will equate to £250,000 which can conveniently be gifted into a flexible IHT mitigation trust to remove it from the tax man’s reach whilst retaining flexible planned access.  So long as the saver/settlor survives seven years this will become IHT free ready to be passed to beneficiaries whenever it appears appropriate (this option is available under a flexible trust during the life of the settlor). 

 Maximum pension/drawdown should then be taken.  This may suffer 40% Income Tax but since (a) it derives from savings which probably enjoyed this level of relief when contributions were made and (b) it has grown in a tax-free environment within the exempt fund, such a tax can be considered neutral.  The ‘pensioner’ will then be in possession of regular slugs of net income.  Of course this is taxed income which is surplus to living requirements and is regular.  Hey presto an obvious candidate for ‘normal expenditure’ gifting.

 Now I am not going to suggest that the recipient gifts this money to his or her beneficiaries completely and immediately free of IHT from that point until death – although I could.  It would seem quite tax efficient.  No I am going to suggest that he or she gifts it, on an immediately exempt basis, into another flexible IHT mitigation trust so  that it too can be available to the pensioner should it ever be necessary.  However, just as with the lump sum arrangement the trustees can also make monies available to beneficiaries during the settlor’s lifetime should this be necessary.

 To put this effect into context consider the retiree who has an untouched pension fund of £1 million and dies one month before his 75th birthday.  His beneficiaries can inherit the whole fund entirely free of IHT.  Contrast this with the same person who lives the extra month and is all set to take his pension under the ASP rules.  He dies within the first month and because he has already gone into ASP his beneficiaries suffer the full 82% tax and penalties and receive only £180,000 (rather than the £1 million they previously would have received).  Can this be right?  The arbitrary nature of the 75 year old deadline is crass to say the least.  This immediately begs the question as to whether the retiree should have taken the tax free lump sum and entered drawdown just before his birthday.  This is a great idea except that a male aged 75 has a life expectation of something like 9 years which is perilously close to the 7 years needed to move the tax free cash outside his estate and escape IHT.  It will also leave 75% of his fund at the mercy of the 82% tax.  Were he to do this and then die his estate would potentially suffer 40% on the tax free cash (40% of say £250,000 leaving £150,000) and 82% on the residual £750,000 fund (leaving 18% of £750,000 which is £135,000).  This would still be worthwhile compared with not taking the tax free cash (beneficiaries would potentially receive £285,000 rather than £180,000) but we can do even better.

 The trick is to take the tax free cash and enter drawdown early enough to reduce the residual fund.  Every monthly pension payment which is taken and transferred into a ‘normal expenditure’ scheme will help address the balance between exempt monies withdrawn and residual fund left behind.  The drawback of this is that the impact of any early IHT charge on the tax free cash and the Income Tax payable on drawings will improve matters greatly for anyone living beyond 75 but will inevitably dilute the returns to beneficiaries if the retiree dies before 75 when the fund would have otherwise been payable free of IHT.

 The following graph shows the impact of taking action early for a retiree aged 66.  The blue line represents the net proceeds available to beneficiaries if the fund is kept until age 75 then goes into drawdown after taking tax free cash.  The red line shows net proceeds if early action is taken.  There is little doubt that the single IHT gift plus normal expenditure route is highly effective beyond 75, especially if the arrangement is started early.  The only difficulty arises if the retiree dies before attaining 75.  This can be simply addressed by the purchase of term assurance in trust to cover the shortfall.  Rates for cover for a 66 year old male per £100,000 of cover are approximately £80 per month for 7 year term (to cover the inter vivos period) and approximately £100 per month for cover to age 75.  This is effective financial planning at its best and makes a good fist of overcoming the pernicious taxes and penalties imposed by Gordon Brown on ASPs in the last Budget. 

 

Assumptions:  Income Tax Rate 40%; Net annual growth rate 6%; 15yr Index Gilt Yield 4.81%;
Drawdown basis 7.5%; Table annuity rate age 75 10.2%; IHT NRB used elsewhere.

 

 

Paul Wilcox,
Chairman & Technical Director, WAY Group.

Posted on 6th November, 2007 |
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The NURS effect on multi-manager funds

In October 1991 they changed the rules on fund of fund unit trusts so that one could buy underlying funds at ‘best’ rather than at creation.  This was a massive change which let the multi-manager genie out of the bottle and, as they say, the rest is history. 

 I was fortunate in being a private client fund manager at the time and had already rearranged most clients’ portfolios into one or more ‘models’ which, in those steam-driven days, we controlled by spreadsheet.  The new rules meant that we could establish a number of new fund of funds unit trusts to replicate our models and conveniently share-exchange most of our clients into them.  This made a huge difference both in our ability to manage actively and to put aside any previous worries about creating CGT liabilities for clients as a result of our active management.

 There was a major drawback, however, as far as I was concerned.  Many of our models (remember this was 1991) had previously included direct Gilt holdings which we bought for individual clients within their portfolios.  This was because it was easier to control individual Gift holdings and their yields than if one bought into what were, in any case, rather expensive Gilt unit trusts.  We had no choice once we had moved to fund of funds because each unit trust was either designated as a securities fund – which could buy individual equities and Gilts – or a fund of funds – which could only buy other funds (including Gilt trusts but not Gilts directly).

 A couple of years ago there was a long overdue and massive change to the regulation of collective funds within the UK with the introduction of UCITS 3 and, in the context of asset allocation, the introduction of NURS (non-UCITS retail schemes).  Many funds launched in the last couple of years have been launched as NURS schemes and several other pre-existing funds have been converted into NURS.  The benefits of NURS within multi-management are absolutely legion, especially as fund management becomes more sophisticated and new and slightly esoteric investment opportunities unfold.

 It is now possible to mix all sorts of asset classes and types within the same fund so that both risk and reward can be enhanced by blending the most contemporary of investment vehicles.  A NURS fund can invest up to 20% in a mix of unapproved securities and unregulated collective investment schemes (including hedge funds).  It can have permanent borrowings of up to 10% permitting a minor level of gearing.  It can comprise larger holdings both of individual securities and of collectives.  Importantly it can invest in property and gold.

 These possibilities open all sorts of doors for the professional manager and as a result many fund of fund managers are choosing to switch their multi-manager portfolios to NURS rules.  This allows them so much more freedom to mix and match investment types and include absolute return funds, structured products, bricks and mortar, funds from strange or specialist jurisdictions as well as commodities. 

 NURS rules permit managers to select funds which are managed very precisely by objective or within very esoteric areas, such as oil exploration or particular commodities.  Funds such as these are frequently closed-ended funds (often investment trusts) which allow their own managers to drive longer term strategies without having to worry about their capital base shrinking or expanding through outflows or inflows of shareholder money.

 A major attraction of closed ended funds is their tendency to fluctuate between discounts and premiums (being under or over valued) depending on market movements.  Often a manager of a multi-manager fund can pick up shares in an investment trust very cheaply where both the sector and thereby the trust are under-valued.  When there is a recovery there is likely to be a double rise enjoyed as both the sector and the fund move northwards.

 Because of the flexibility within NURS and the increased choice and complexity of options available to managers and, particularly, to multi-managers, there is a far greater degree of skill and experience which must be brought to bear.  This is why returns from well run multi-manager portfolios, which have always tended to be superior to single manager funds within each relevant sector, are becoming ever more competitive.

 There has always been a strong case for multi-management in achieving economies of scale, tax-efficiency, wider diversification, lower risk and higher returns, compared with running individual portfolios of shares or collectives.  But the recent emergence of highly sophisticated asset blending with judicious use of derivatives and other contemporary vehicles, following the introduction of NURS rules, means that the performance gap between old style collectives and new style funds is likely to increase even further as time goes by.

 This differentiation has brought multi-manager investing to new levels of sophistication.  Nowhere is this more obvious than within the Cautious Sector where managers can now incorporate absolute return funds, guaranteed funds and property funds into the mix to reduce both volatility and the degree of correlation between cautious funds and the equity markets.  It is time for investors to re-evaluate the quality of NURS funds operating within the Cautious Sector.

 One of the great difficulties is the preoccupation within the market place for looking at performance tables.  Many truly cautious funds, such as WAY’s own, have a benchmark equity weighting of some 30% against an IMA benchmark for the cautious managed sector of “up to 60%”.  This means that these more cautious funds will always under-perform the sector during bull market conditions because they have far less of an allocation to the single asset class which is going like an express train. 

 One has to ask whether a portfolio which contains 60% equities can reasonably be described as cautious.  To my mind we are still operating in sectors based on investment considerations from the last century.  In today’s markets there is much greater sophistication.  When one currently talks of caution we are not talking about focusing on high income equities or simply reducing the equity allocation by a few per cent, we are talking about a well-diversified portfolio containing a range of asset classes including property, absolute and guaranteed funds.  These will deliver lower volatility and robust cautious performance but they will not deliver 60% of equity performance!  Whilst the IMA Cautious Sector is full of equity income funds earning star ratings, the genuinely cautious funds will get little credit for the wonderful job many of them do for their cautious unitholders.

Paul Wilcox,
Chairman & Technical Director, WAY Group.

Posted on 15th October, 2007 |
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Going the extra mile

What differentiates an IFA from the crowd, what allows him/her to demonstrate TCF, what proves to the Revenue that a trust is genuine and not merely an artifice which requires no trustee input?  One answer to all these questions can easily be that the IFA recommends a flexible trust solution for IHT mitigation purposes rather than the simple but completely inflexible expedient of a discounted gift trust.

 By recommending a discounted gift trust an IFA is very likely helping the client to avoid either a little (if they live less than 7 years) or a lot (if they survive 7 years) of Inheritance Tax.  This is terrific so long as the client does not have too much reliance on the funds within the trust, especially if his or her circumstances were to change.  Unfortunately, however, to make a serious impact on the potential IHT bill one often has to shift substantial sums out of one’s estate and to do so every 7 years to repeatedly utilise the Nil Rate Band.  In these circumstances one really cannot afford to put the funds into Purdah for the rest of one’s life.

 They do say that men retiring at 60 will probably live until they are 85.  This gives the 60 year old retiree at least 3 stabs at the IHT Nil Rate Band.  Bearing in mind that I am fast approaching the first of those ages myself, it is sobering to think about how the lives of some of my friends within my peer group have changed very dramatically without warning in these later years.  Do the exercise yourself and you will know what I mean.  In my own case I have been ‘best man’ on two occasions for close friends and neither survived to see 60.  A further number of both sexes have become widowed and remarried.  In other cases serious illness has inflicted itself on the family.  Other friends again have had to bail their children out of failing business ventures or bad marriages.

In all of these cases they have needed flexible access to some or most of their money.  This is fine whilst it is in their estate and vulnerable to IHT but impossible if it is tied up in a discounted gift trust.  Having a fixed ‘income’ and no access to capital at all for anyone, regardless of their needs, is not great.

 The Flexible Trust route for IHT mitigation does not offer any discounts on the gift but that can be remedied with a little 7 year term assurance.  What the flexible route does do is make the trust very real because the trustees are obliged to make annual decisions on settlor reversions and loans or appointments to beneficiaries.  The scope for Revenue attack on the basis of artificiality is absent.  It also means that the advising IFA has demonstrably put the client first and is treating him or her incredibly fairly.  Finally it will almost certainly mean that the IFA is not simply replacing an IHT liability with an Income Tax liability – something which generally happens with a discounted gift trust – but is mitigating all taxes.

 So, my challenge to all IFAs out there is to ‘step up’ and show your professionalism by going the extra mile and switch your allegiance to flexible IHT trusts.

Paul Wilcox,
Chairman & Technical Director, WAY Group.

Posted on 30th August, 2007 |
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Treasury delighted – it’s the ISA season again

The annual ISA momentum is building.  Our doormats are dancing to the impact of ISA circulars from any and every financial institution we have ever dealt with and many others with which we haven’t.  The effort of selling ISAs to clients each year and the danger of selecting what turns out to be inappropriate funds, all for very little reward, means that many advisers leave the annual ISA scrum to the direct sellers.  However, there is every good reason for advisers to revisit this whole scenario and do themselves, their clients and companies like WAY an enormous favour. 

Who benefits from ISAs?
By stealth tactics the Treasury is misleading investors into thinking there are substantial tax benefits in retaining PEP and ISA portfolios into one’s dotage, while simply ensuring that it can continue to collect large amounts of IHT from the unwitting and unprepared elderly investor.  I believe investors from their mid-sixties onwards who believe they will have an IHT liability should no longer be investing in or holding PEPs and ISAs.  What so many of them do not realise is that they will suffer a punitive IHT sting at death, whereby they and their families potentially lose a colossal 40% of their hard-earned savings.  This loss completely dwarfs the often marginal annual tax benefits resulting from the ISA wrapper. 

Based on Office of National Statistics figures for holders of ISAs and PEPs, combined with our own research, WAY Group estimates that at least 165,000 elderly investors (aged 70 or older) are holding ‘tax-sheltered’ portfolios in excess of £100,000.  Based on published mortality rates this would mean that at least £0.5bn, or one sixth of the annual total IHT tax take of £3bn, arises from IHT on PEPs and ISAs from this group!  This cannot be right. 

I believe that there are substantially more then 300,000 investors across the country who currently hold substantial equities-based tax-free investments within their portfolios with no provision whatsoever for these funds to be transferred into alternative investment schemes which can mitigate the IHT. Over half of these investors – some 165,000 – of those with large tax-sheltered investments are aged 70 plus. This is the age group at the greatest risk of losing out on the tax-free benefits of their savings strategy. 

So what can these investors do to avoid IHT on their ‘tax free’ savings?  There are two parts to the answer, the first relating to accumulated savings already within PEPs and ISAs and the second dealing with future surplus annual income which might otherwise have been directed to ISAs. 

Accumulated PEP and ISA Savings
The obvious solution for redirecting accumulated savings is simple, even after Gordon Brown’s Budget measures from last year.  They should encash up to £285,000 of their ‘tax-free’ savings and gift them to their chosen beneficiaries via a flexible trust.  Although gifts into such trusts now constitute an IHT taxable transfer there will be no tax so long as the gift is within the current Nil Rate Band for IHT – £285,000 per person.  Such gifts fall out of account after 7 years and so there is an opportunity for each taxpayer to make gifts up to this level every 7 years. 

At age 65 the average investor still has a life expectation of some 16 years (males) to 19 years (females).  Even at age 75 these numbers are 9+ and 11+ years.  This means that any average investor has time to gift their former PEPs and ISAs completely IHT tax-free so long as they start shortly after their mid 60′s.  The real benefit of the tax exemptions associated with PEP/ISA portfolios is that when this IHT mitigation exercise becomes appropriate the targeted funds can be surrendered entirely tax-free at that point, making investment in an IHT mitigation plan that much more effective.

 There are a number of schemes available whereby trustees have a great deal of flexibility in making financial provision for both donors and beneficiaries. This means that investors can switch into IHT-protected investments knowing that their savings are beyond the tax man’s reach but not beyond their own reach, courtesy of their chosen trustees. Any investor with £250,000 in PEPs and ISAs is likely to save £100,000 of IHT by moving across to an IHT mitigation arrangement.  We are talking substantial potential savings here – the kind of savings which investors cannot ignore.  Not only does the client benefit but IFAs can earn worthwhile commissions or fees as compensation for the very complex work involved in establishing and monitoring the necessary trusts. 

Substitute for future ISA Savings
Many investors habitually save the maximum ISA allowance each year to obtain scraps of tax benefits which fall from the Chancellor’s table.  These sums simply compound the 40% wealth tax which Gordon Brown (or his successor) will collect on the taxpayer’s death.  So is there a more efficient use for these amounts of, generally, surplus income which will deprive Brown of his unjust desserts and yet benefit the investor? 

 Taxpayers have been using the ‘normal expenditure’ from income exemption introduced by Section 21 of the IHTA 1984 for many years.  This is normally exercised by straight unconditional gifts or by the establishment of simple trusts.  The fact that such gifts are immediately exempt from IHT is an exceptional benefit.  However donors making such gifts have hitherto been deprived of any future benefit.  Anybody unsure about putting funds beyond reach has therefore not taken advantage of this facility.  Since last summer WAY has offered it’s unique ‘Gifts from Income’ Inheritor Plan which allows donors to make instantly exempt gifts into a specially drawn trust but retain influence over those monies, including the right to have them reverted at some time in the future.

 What this means in simple terms is that investors who qualify for making ‘normal expenditure’ gifts can make regular savings not into ISAs, which will incur the 40% IHT charge on death, but into a Gifts from Income IHT arrangement, which offers instant IHT exemption (no waiting for the expiration of the 7 year inter vivos period).  Advisers only have to complete trust documentation with clients in the first year.  In subsequent years it is only necessary for funds to be paid across.

 The only caveat on this arrangement is that the regular gifts do genuinely qualify for the ‘normal expenditure’ exemption.  There are 3 rules for this: (i) the gifts (into trust) must be regular, (ii) they must be gifts from surplus net income and (iii) making the gifts must not adversely affect the donor’s standard of living.  So long as these conditions are met there is no limit to the size of regular gifts.  Some investors have substantial surplus income, sometimes tens or hundreds of thousands of pounds, which can be gifted in this way with immediate IHT exemption.

 So my message is clear – together we can help our clients and ourselves to obtain substantial financial benefits from switching from an ISA to an IHT mitigation approach where the only loser is the tax man.

Paul Wilcox,
Chairman & Technical Director, WAY Group.

Posted on 2nd March, 2007 |
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Time for a pragmatic approach to risk profiling

Ever since the end of the ‘bear’ market in the Spring of 2003 I have been struck by the energy and intellect which has been directed at the issue of establishing each client’s attitude to risk.  Such paranoia has been evident after all previous major stockmarket corrections: after 1974, 1987 and now since 2003.

 Frankly nothing has changed in the last 100 years let alone the last 30 or so since we were all encouraged to bath together to save energy!  The message should be clear to us all: in the short term cash is king but in the long term equities unquestionably are king.  This truism is fundamental to the whole premise for free market economics.

This leads me to another fact which has been obvious to actuaries and scientists since economics was invented.  This is that volatility on any long term chart always looks as if it has been greater in recent times than in previous periods.  This is an optical illusion used by sceptical would-be investors to ‘prove’ that it is no longer worth investing in equities!  In fact the nature of an exponential curve (the natural profile of a long term equity index) is that apparent volatility only looks to be less the further back you go.  This is amply demonstrated by looking back at Black Monday and the 1987 ‘crash’ which it heralded.  This was a significant bear phase (as can be seen on the chart) which has subsequently faded into the context of what it really was . . a blip or straightforward market correction.  Suddenly, with markets touching previous highs, the recent ‘crash’ also begins to look like a natural and unexceptional market correction.

 The chart clearly shows the difference between market price and likely intrinsic value.  Whilst market price is largely determined by the balance (or imbalance) of willing buyers and sellers it is clear that it fluctuates around real value.  There is no way that the value of a company like Tesco fluctuates with its share price.  Its value generally moves rather more gently to reflect the long term trends of its fundamental balance sheet, profit and other financial ratios.  What the chart actually highlights is the importance of time rather than timing.  Whilst timing may be important in the specifics of buying and selling – far better to buy when prices are below value and to sell when they are above value – it is time, holding a high quality, actively managed portfolio for the longer term, which delivers sound sustainable returns.

 This, the fourth dimension of time, should be the starting point for discussions about risk.  I believe that one can establish a neutral and totally practical approach to risk from which one can then deviate for more cautious or more adventurous investors.  Developing a matrix from the premise of ‘short term cash is king, long term equities are king’ is straightforward and simply requires filling in the gaps between short and long term.  I consider short term to be up to 5 years whereas I believe long term means beyond, say, 12 years.  If 0-5 years means all cash and therefore nil equities and 12+ years means 100% equities then we can simply interpolate between these points.  I would say 5-8 years means 20-30% equities whilst 8-12 years means 50-60% equities.  Clearly it is also very important where the non-equity balance is invested but assuming this is also risk-graded in some sensible way we have a good working model for most average investors.

 Any investor investing for the future should attempt to predict the investment time horizon for different portions of his/her capital and then invest accordingly – in a different style of portfolio or fund for each time period.  The idea of determining each client’s ‘risk profile’ and then matching asset classes to this preference completely misses the point.

 As I see it the average investor would benefit from being in cash for any short term requirement and in a well-spread, actively-managed equity portfolio for long term requirements.  It is certainly not low risk for investors to be stuck in cash for the longer term.  Such an approach would be irresponsible – as the court has ruled in some well-known trust cases.

This brings me on to the contemporary approach of asking clients to complete long and tortuous risk questionnaires at the end of which, in true ‘Little Britain’ style, “computer says you are a cautious investor!”  Clients do not understand this process nor do they have sympathy with the conclusions.  If advisers follow this route to protect themselves, from a compliance perspective, I rather doubt its long term effectiveness.  Clients need to thoroughly understand how the conclusion about their risk tolerance was ascertained otherwise it might be considered false.  Frankly, a simple enquiry as to whether they believe they are cautious, neutral or adventurous investors would likely have been more effective. 

 I abhor such questionnaires.  Instead of subjecting clients to this torture I recommend a meaningful discussion about the nature of equity investment, its inherent volatility and the part played by time.  Such open and practical discussions should be properly documented.  The client should then be encouraged to analyse his/her future capital needs into time horizons.  These will then indicate a neutral position from which one can vary to reflect how adventurous, or otherwise, they are.

The era of the 1-10 risk categorisation of both clients and asset classes is long gone, thank goodness.  Matching a category 3 client with a long term Gilt approach never did make much sense.  In my view, however, we are going overboard with the academic approach and yet have still finished up categorising clients too broadly rather than looking at the main factor in risk – time.  So I give you my complete thoughts on basic risk profiling in the table.  Neutral means investing in the most obvious portfolio styles to reflect time horizons.  Only then should one consider the impact of the non-neutral client!

 

	5-8 years	8-12 years	12+ years
Low Risk Approach	Cautious	Cautious	Cautious
Low to Neutral Risk Approach	Cautious	Cautious	Balanced
Neutral Risk Approach    Typical equity content	Cautious 20-30%	Balanced 50-60%	Growth 90-100%
Neutral to High Risk Approach	Balanced	Growth	Growth
High Risk Approach	Growth	Growth	Growth

 

  

 

 

 

Paul Wilcox,
Chairman & Technical Director, WAY Group.

Posted on 24th October, 2006 |
Comments: Have Your Say

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