One of the maddening things about our financial services industry is how slowly it has been innovating to help the growing ranks of the relatively rich and retired.
Take equity release mortgages. They should be the perfect product – a great way for older people to stay in their homes but also withdraw cash from those homes so they can live nice lives. That can happen, but they are still often too restrictive and expensive. Once the interest has compounded over the remainder of a lifetime, heirs tend to find that the costs have eaten the house.
You could argue that this doesn’t matter (no pockets in a shroud and so on). But given our general obsession with leaving stuff to our kids, it does matter.
Welcome, then, to the Retirement Interest Only (Rio) mortgage, a variation on the theme that allows the retired with some income to withdraw capital and pay interest on it monthly. These aren’t perfect: they can still be too expensive; they don’t always come with long-term fixed rates; and they obviously aren’t much use to anyone who is already short of income.
But there are now some good-looking products on the market. Legal & General’s Optional Payment Lifetime Mortgage comes with rates as low as 2.93%, fixed until you die or move into care, for example. Make a spreadsheet or two and you can see how they might work for you.
A little arithmetic
Some rough sums. Say I’m 65. I have £500,000 in a Sipp, a house worth £1m, and a defined-benefit pension that, with the state pension chucked in, gives me enough to live on. I go to a sympathetic organisation and get a Rio mortgage of £500,000 at 3.9%, secured against my £1m house (3.9% being the rough rate private bank Weatherbys tells me they can lend at to clients with a “strong credit profile”). I live to be 80. During those 15 years the interest will roll up to £292,400. Sounds insane, doesn’t it?
But now look at the rest. Let’s say I make a real return on the Sipp portfolio of 3%, which is not unrealistic over a 20-year period given the historical return from equity markets of 6%.
Anyway, for the sake of conservatism we will stick with 3%. Thanks to the magic of compounding, that 3% real growth means that my pension assets are now worth £785,000 (remember everything in my pension rolls up capital gains and income tax free). I’ve made about the same in returns as I have in interest.
That’s nice – and it’s worth noting, too, that if I live to 85 my returns will overtake my interest significantly. But it isn’t the main point. My Sipp pension would normally now pass to my heirs free of inheritance tax. They do pay income tax on withdrawals from it if I die past the age of 75 but they can manage the timing of those to minimise that downside. I’m assuming that house prices went up 3% a year in real terms every year, making my house saleable at £1.57m. My estate pays back the £500,000, leaving housing assets of £1.07m.
Assume that the inheritance tax allowance does not rise in real terms every year. It hasn’t risen at all since 2009, and while it should rise at least in nominal terms there is no obvious reason for it go up in real terms. Assume, too, that I have been part of a married couple, that I am using the family home allowance and I now have taxable assets of £70,000 (I used up the £500,000 cash from the initial mortgage deal on paying the mortgage and going on cruises).
The inheritance tax bill? £28,000. Amount passed on to kids? £785,000 plus £1.07m minus £28,000. So £1,827,000. If I had spent the pension instead, my taxable assets would now be the full value of the house plus – and this is where it gets a bit complicated – whatever I have saved from my defined benefit scheme as a result of using up the pension. For the sake of simplicity and spreadsheet exhaustion avoidance, make that the same as the total interest – £288,900. So £1,858,900 with an inheritance tax bill of £343,560. Total passed to kids? £1,515,340. There’s a real money difference here.
I’ve barely started with the sums on this. This is not the same for everyone – it depends on rates, on what other assets you have, what types of pensions you have, the interest rate (the numbers would look better here if I had gone with L&G) and a horde of other factors. But you get the point – there are all sorts of neat opportunities hidden in our horribly complicated financial architecture, things that IFAs and wealth managers can help you see.
Little is likely to change any time soon
You might say this is all too complicated. It could be – and God knows there are enough people in the UK with the experience to tell you that complicated tax avoidance ends in tears. You might also say that this stuff will change soon.
There are hints of changes coming to inheritance tax. The chancellor and the communities secretary have both hinted at major shifts and, says George Bull of RSM, an accountancy group, “potentially even its abolition”. This seems unlikely. Abolition would surely come with tax compensations (capital gains paid on the assets in your estate on your death, perhaps) but nonetheless the £5.4bn take from inheritance tax isn’t something for a fiscally challenged government to want to give up. More likely, says Bull, is that we see changes to “certain reliefs and exemptions”.
Pension assets could easily fall into that category. The Queen’s Speech is unlikely to suggest any sudden change to the way pensions work (all this needs consultation) but it doesn’t seem unreasonable to expect yet another overhaul of tax relief and contribution limits at some point. And none of us would be madly surprised if some bright spark in a Corbyn government were to suggest a pension-specific wealth tax for anyone with pension assets over, say, £500,000 – although, were that to be extended to those in the public sector, that would be financially unpleasant for people such as Corbyn.
But the point here is not that you should rush out and get yourself a Rio mortgage. It is that while we spend a lot of time talking about how you should allocate your assets, which fund you should buy and how you should make sure that you keep your costs as low as possible, how you structure your finances could be more important. I wish that wasn’t so – and if the UK had a simple tax structure it wouldn’t be. But it doesn’t.
So before you fret about whether you should be in Vietnam, the US or Japan and how much 0.1% worth of fees here or there matters, make sure you’ve looked at the bigger picture. It could save you – and your kids – a fortune. Price matters. Sometimes structure matters more.
• This article was first published in the Financial Times