Providing for the future

Ian Dyall, Steve Hamp and Jeremy Pearson take a look at the effect prevailing economic conditions have on IHT planning and how clients are reacting

How has the current financial crisis affected people's inheritance tax planning strategies?

Dyall: Fundamentally, no matter what markets prevail, clients have the same core desire when it comes to estate planning - to optimise the way they leave their wealth to the people who matter to them, and they need to do this without hampering their access to the money that they may need for the future.

The key solutions available do not change either, so we are still using the same systematic approach - make best use of any allowances, reliefs or exemptions; reduce the estate by gifting or spending (often using trusts); then pay the remaining liability efficiently using life assurance (if appropriate). We believe that this is still as valid today as it ever was.

What has changed are our clients' attitudes to estate planning, and on many occasions these are positive changes. Clients are now more aware of the importance of having a quality investment portfolio backing the estate planning solution, so we see far fewer clients who are adamant that they want AIM shares when they are clearly unsuitable for their investment objectives. Clients are also far more willing to consider selling property portfolios or individual shares in order to plan for estate planning. Finally they now appreciate the importance of taking advice from people they trust. So estate planning is as important to our clients, and as important a part of the advice we offer as it was previously.

Hamp: When making any investment, one of the key aspects will be the access the client has to that investment. Clearly an investment that restricts access for any reason is likely to be less attractive in the current climate. Generally speaking, an outright gift into trust for inheritance tax planning will be a potentially exempt or chargeable lifetime transfer, both of which restrict the access to capital and/or income in order to preserve its status as a gift.

The current financial market volatility appears to have had the effect of raising the appeal of discounted gift trusts and loan trust, where there is access to income and/or capital while retaining a proportionate inheritance tax mitigation value.

Pearson: The crisis has led to inaction rather than a change of strategy. For most people, it has meant that the value of their assets has dropped sharply and their potential inheritance tax bill has fallen. In fact, HMRC is now predicting that only 3% of estates will pay inheritance tax as opposed to 5% last year. But, you have to remember that the transferable nil rate band was introduced during that period, which has also reduced the numbers.

For existing clients, inaction may be the best policy, because the crisis will pass (we hope!) and the existing planning will prove its worth.

What we have seen, however, is many trustees changing their investment strategy in the trust - be it switching investments or cashing in investments with certain providers and reinvesting the proceeds in something more in line with the aims of the trust.

Clients who are loath to commit lump sums at this stage are more open to the suggestion that if they have surplus income, they could make use of the often overlooked normal expenditure out of income exemption. Utilising this, a significant trust fund can be built up over the years using savings accounts and taking advantage of cost-pound averaging.

Are you finding that people have to access the capital from their trust rather than income as the value of their investments has gone down?

Dyall: Our estate planning solutions have always been deliberately conservative. We see estate planning as a balance between tax saving on the one hand versus access to funds on the other, and ultimately we would rather the client saves a little less tax than they could, in order to be confident that they maintain the access they need. So generally we have very few issues with our own clients. However, there are a number of bear traps that advisers and clients with a more aggressive approach may fall into if they get that balance wrong.

For example, discounted gift trusts are a popular solution to a client's needs, and rightly so. However, other than the predetermined 'income', there is no access to the trust fund (even for the ultimate beneficiaries), the income is generally fixed and therefore susceptible to erosion due to inflation over the long term, and in bear markets the predetermined withdrawals can lead to a reduction in the fund value particularly with higher withdrawal levels. We are seeing a number of new clients for whom this has become an issue, and they are looking for advice on how to rectify the situation. Where it is possible to access assets from the trust, for example loan trusts or trusts where they are a potential beneficiary, we will help them to do so, but ultimately I believe that ensuring that this never becomes an issue is better than trying to remedy the situation once it has become an issue.

Hamp: Returns on trust assets in general will have undoubtedly reduced over the past 6-12 months. Although those that are receiving the natural income via a collective investment may be enduring a period of low to zero income, those that are invested in an investment bond and taking 5% tax deferred withdrawals are still likely to be drawing on income rather than growth currently. This is a challenging position as drawing an income from a falling asset accelerates the losses.

If an asset suffers a 50% loss, the growth required to get back to parity is now 100%. This is undoubtedly why an optional guaranteed income and death benefit offered by some product providers, including The Hartford, is proving so attractive in the current market.

Pearson: This is not a question that can be answered in general, as it all depends on the type of trust involved.

If we take the example of an interest in possession trust typically established through a will, there will be a beneficiary entitled to the income arising from the trust investments (the 'life tenant'). With interest rates plummeting and dividends being cut, the life tenant's income drops. The trustees may be able to top-up the income by advancing capital to the life tenant, but this is only an allowable option if the trust terms include a power of advancement. Trustees who pass capital to a life tenant from a trust which lacks such a power could be accused of 'breach of trust'.

And in any case, even if the trust terms do allow capital payments to a life tenant, the trustees are duty bound to balance all the interests of all the beneficiaries; including those of the 'remaindermen' who benefit from the trust fund after the death of the life tenant. If capital is advanced to the life tenant, their expectation reduces. A tricky situation for the trustees, with no easy solution.

As regards standard insurance bond trusts these are often structured so that the settlor is getting regular monthly or yearly payments from the bond, as in the case of a discounted gift trust or a gift and loan trust. The settlor may look on those regular payments as income but of course an insurance bond does not produce any true income and the regular payments are simply capital payments. In these recession times the issue is not that the income is reducing, it is that by continuing to dip into the capital, the settlor is pushing down the value of the trustee's investment bond even more alarmingly. It is conceivable that if the settlor's regular 'income' payments continue and the recession is prolonged there may be little or nothing left in the trust for the beneficiaries!

With gift & loan trusts or reversionary interest trusts, this income (in the form of bond withdrawals or maturities) can be stopped for the time being until such time as the value of the bond recovers. But this is not possible for the popular discounted gift trust where the payments to the settlor must be specified at outset and paid for life.

It is entirely conceivable that following the settlor's death, the investment bond in a discounted gift trust could be worth less than the discounted gift value and so IHT calculated using a higher figure than the beneficiaries will actually receive!

Is the current situation prompting people to delay setting up trusts as they feel uncertain about their finances?

Dyall: Although clients are now more aware of the importance of having quality investments backing their estate planning solution, the desire to save their beneficiaries a large tax bill means that estate planning is far less market sensitive than other areas of investment planning.

The reduction in the value of people's estates and the recent changes to the nil rate band legislation may have reduced the number of people with an inheritance tax liability, but there is another group of people who were put off inheritance tax planning due to the potentially large CGT liability involved in rearranging their assets. These people are now keen to act while their investments have smaller gains.

The Conservative Party's £1 million nil rate band proposal was causing some clients to consider delaying decisions, but in the light of the escalating national debt and Ken Clarke's recent comments on this proposal, many are now considering whether the proposal will ever be implemented and if so how long they will have to wait before it is.

Our estate planning solutions have always been deliberately conservative. We would rather the client saves a little less tax than they could in order to be confident that they maintain the access they need. Once clients understand this approach and the importance of not leaving their planning too late, they can usually see the potential problems of waiting for 'better times'. So we are helping as many people today with their inheritance tax liabilities as we were two years ago.

Hamp: Rather than delay, the current situation is forcing clients and advisers to re-think their strategy for inheritance tax mitigation.

For example, it is likely that we will see the wider use of a loan trust in the coming months and potentially years. This type of arrangement, as the name suggests, is a loan rather than a gift which must be repaid back into the estate on death, or over time in the form of withdrawals. If the withdrawals are no greater than 5% per annum, and this money is spent, then the taxable estate will reduce over time with the growth outside of the estate immediately and permanently.

As the asset in trust is a loan, all of the remaining capital can be withdrawn at any time meaning the client has a greater element of control and certainty - whatever their future circumstances might be.

Pearson: Imagine you are the compliance officer at an IFA firm. A consultant submits an estate planning case on the basis that the client normally pays much more IHT, but because of property values and share prices the estate is lower than usual. So the consultant's advice is based on what the client's estate is usually worth, not today's actual figure. There is no way you could allow that to proceed, could you?

The effect of the current situation is firstly that we do not know how long the current crisis will last, so until a stable environment has returned clients are holding off making a commitment. And if they do proceed, the trust reflects the current value of their estate which for most people is less than normal.

Delaying taking action can be costly of course, because the proverbial seven-year clock does not start ticking until the trust is established. We all have clients who died six years and 11 months after making a potentially exempt transfer, their family rueing that they didn't take action just a little bit quicker and the taxman being grateful they didn't.

Are you seeing any demonstrable trends when it comes to the trusts that are being set up? Are there any particular types of trust that are becoming particularly popular? If so, why do you think this is?

Dyall: Discounted gift trusts have become very popular for a number of reasons, some positive, some less positive.

On the positive side, many clients have an inheritance tax liability due to the growth in the value of their capital assets, for example their home. However, although they are wealthy from a capital perspective they are not necessarily wealthy in terms of income. They would love to give away the capital value of their assets, but they need to retain the income. A discounted gift trust is a great way of doing this and is therefore a popular solution.

On the less positive side, many discounted gift trusts appear to have been sold on the back of the discount alone, and in some cases in situations where the client already has an excess of income that they are struggling to get rid of. The discount is obviously attractive to clients because we all like instant solutions, but if the client does not need the 'income', this can lead to problems, as it is likely to build back up within the estate and undo all of the benefits of gifting the money in the first place. The 'income' cannot be simply gifted away as a 'gift out of expenditure' as it is not really an income but capital withdrawals from an investment bond. I have even seen situations where the income has been set as high as possible in order to maximise the discount, which has not only lead to the issue previously mentioned but also has resulted in serious erosion of the fund value. I believe that a simple gift trust is often a better, but under-used solution.

Hamp: For the reasons I already outlined, the loan trust is becoming popular again. However, the discounted gift trust (DGT), which removes an element of the gifted asset from the estate immediately, remains as popular as it has historically been.

The right to income from this type of arrangement means that the gift is providing some long-term value over and above the potential inheritance tax mitigation. What has started to happen is that advisers are thoroughly reviewing the underlying investment within a DGT as this is an arrangement where income most certainly will be being taken.

In positive years it is hoped the growth will outweigh the withdrawal. During years of negative growth, this could irreparably damage the fund. This is making products with guaranteed income look increasingly attractive and we are starting to see existing DGT assets transfer to these types of products.

Pearson: With regard to will planning, there has been a tendency to not necessarily include discretionary trusts in wills any more. These were almost a default provision in wills before the advent of the transferable nil rate band, but although there are still good reasons for including them in particular circumstances, simplicity seems to have returned to will planning.

But there has been an increase in the popularity of interest in possession will trusts. This is often because a client with children from their first marriage gets married to someone in the same situation. They obviously want their new spouse to be financially well provided for after their death, but would want their estate to go to their children on the second spouse's death and not the step-children. This request can be fully accommodated by having wills making the surviving spouse a life tenant of the deceased's estate with the deceased's children from their first marriage being entitled to the capital on the survivor's death.

As far as packaged estate planning solutions are concerned, with uncertainty comes a desire to not make commitment. There is a tendency for clients to prefer gift and loan trusts or reversionary interest trusts as opposed to the strictures of a discounted gift trust. But this is somewhat tempered by the attraction of the improvements in the discount rate as a result of HMRC reducing their official interest rate recently.

Provider biogs

Ian Dyall is senior estate planning product specialist at Edward Jones

Ian joined Edward Jones in February 2006 as a product specialist responsible for the marketing of estate planning.

Prior to joining Edward Jones, Ian spent 16 years with an insurance provider including eight years as an adviser, four years in sales training, two years in campaign marketing and the final two years in a team dedicated to all aspects of estate planning. His breadth of experience enables Ian to look at estate planning and other areas of financial planning from a variety of viewpoints.

- About Edward Jones

Edward Jones offers face-to-face advice, employing a long-term strategy that emphasises quality and diversification. The firm offers financial advice and stockbroking services to help our clients achieve their financial goals. Edward Jones Financial Advisers provide advice in the areas of investments (collective investments, stocks and shares, and fixed income products), pensions, estate planning and personal protection.

Stephen Hamp is the head of the technical and training division at Hartford Life

Having started his financial services career in 1993, Stephen has built his career across a number of fields such as pensions technical advice, actuarial and accounting, marketing, and from 2000 to 2007 in sales management, where he was a regional sales director with national advisory firm Millfield.

Stephen joined The Hartford in 2007 as technical manager and is responsible for the team that provides The Hartford's internal and external technical information and support.

- About The Hartford

The Hartford is one of the largest financial services companies in the US, with international operations located in the United Kingdom, Ireland, Japan, Canada and Brazil. Established in 1810, The Hartford has over 195 years of experience. The Hartford prides itself on a superior level of customer service. In 2008, it claimed the top spot for the five star Life & Pension category at the Financial Adviser service awards.

Jeremy Pearson is technical support manager at Canada Life

Jeremy has many years experience in financial services, having worked for life companies and an IFA in technical roles. He joined Albany Life in 1989 as regional IFA support manager, specialising in estate planning. In 1993 he moved to their head office as a technical specialist in their marketing department. After Albany's acquisition by Canada Life in 1997, he took over the role of IFA technical support manager, providing technical assistance as well as promoting a range of estate planning solutions. He helped establish the technical support team in 2003, bringing with him his analytical skills as well as his technical knowledge of financial planning and taxation.

- About Canada Life

Canada Life Limited, a wholly owned subsidiary of Great-West Lifeco, began operations in the United Kingdom in 1903 and looks after the retirement, investment and protection needs of individuals and companies alike. As well as providing stability and security through its individual contracts, Canada Life Limited has grown to become the leading provider of competitively priced group insurance solutions. www.canadalife.co.uk/ifa.