Growing evidence is suggesting pensioners with larger defined contribution pension pots are starting to run them down much faster – or use them up in full – in a bid to reduce potential inheritance tax (IHT) liabilities.
From April 2027, unspent defined contribution pension pots will be added to the value of the estate when inheritance tax is worked out. Likewise certain defined benefit death benefits such as ‘death in deferment’ lump sums. The changes were announced in the 2024 Budget.
The government estimates the move will bring around 10,000 estates each year into paying inheritance tax for the first time as well as increasing IHT bills for a further 40,000 estates.
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But the long gap between the announcement of the change and it being implemented has given wealthy pension savers and their financial advisers time to put in place a range of strategies to offset the impact of the move.
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This impact is most likely to be seen with larger pot sizes where the inheritance tax risk is greatest.
Steve Webb, partner at pension consultants LCP and a former pensions minister, said: “For many years, one of the attractions of defined contribution pensions has been their favourable treatment under inheritance tax rules, especially for those with larger pots.
“But the 2024 Budget announcement has changed things, and people with larger pots are now exploring a range of strategies to reduce any potential IHT bill for their heirs.”
What are pension savers doing to avoid inheritance tax?
Pension savers are increasingly turning to two financial products – annuities and whole of life insurance policies – to help them overcome the fact pensions will be subject to inheritance tax from April 2027, Webb says.
Annuities
Annuities allow savers to convert some or all of their defined contribution pot into a lifetime income stream. This income can be potentially gifted using the “normal expenditure from income” exemption.
Provided the rules are followed, these gifts can immediately be exempt from IHT.
If a joint life annuity is bought, then this carries on after the death of the first person. This is free from inheritance tax for the second life, even if the couple aren’t married or in a civil partnership.
There has recently been a surge in annuity purchases bought with larger pension pots. Sales of annuities over £250,000 rose by 31% year-on-year in 2025, and sales of annuities valued at over £500,000 rose by 54%, according to data from the Association of British Insurers (ABI).
In the case of an annuity, those in poorer health will generally get a better rate, as the annuity will pay out for a shorter period.
Whole of life policies
With ‘whole of life’ insurance policies, savers can pay for regular premiums for a policy which pays out a guaranteed lump sum when the saver dies. These payouts are free of inheritance tax, provided the policy is set up under a trust.
Alternatively, this lump sum could pay for any inheritance tax bill.
In the case of a couple, the policy can be set up to pay out on the ‘second’ death, meaning that it pays out only at the point the estate passes between generations. This reduces the cost of the policy. Doing it this way is known as a ‘joint life, second death’ policy, and typically applies for deaths up to age 90.
Industry sources suggest a surge in demand for whole of life policies, with an increase of 92% year on year reported in Spring 2025.
The terms for whole of life policies will generally be better for those in good health, because the premiums will run for longer and the expected payout date will be later.
Webb said: “Defined contribution pension providers can expect to see changing behaviour amongst savers with the largest pots, with more interest in drawing down more rapidly for gifting or purchase of a whole-of-life policy, or even using the whole pot for annuity purchase. Providers may find that the largest pots disappear the quickest post-retirement.”
Annuity or whole of life policy – which is best to avoid inheritance tax?
Financial advisers will be able to recommend the right strategy for each individual, but according to Webb, factors which pension savers are likely to consider if deciding between an annuity or a whole of life policy include:
Timing: With the annuity option, the pension saver is ‘giving while living’ – passing on regular income immediately to heirs. By comparison, a ‘whole of life’ policy delivers a lump sum on death.
Health: Those in poor health could potentially get favourable annuity terms, though risk giving up their capital for a relatively limited payout period. Meanwhile those in good health could get favourable terms from a whole of life policy, especially one which only paid out on the ‘second death’ in a couple.
Adjusting for inflation: Whole of life premiums can be fixed in cash terms, providing assurance the policyholder can keep up the payments for life, or can be set to increase, thereby helping to maintain the real value of the eventual payout.
With both a whole of life policy and an annuity, the policyholder will need to keep records so their heirs can demonstrate ‘where the money went’ while the saver was alive, to ensure HMRC do not attempt to add the money gifted (or spent on premiums) back into the estate after death.
Clare Moffat, pensions and tax expert at Royal London, said: “It is clear that there is growing interest for clients who might be affected by IHT in financial products such as annuities or whole of life policies. But the options are complex and it may be worth an inheritance tax bill if that makes family members better off.
“Most people would benefit from taking professional financial advice so they can work out the best course of action for their specific circumstances.”
We look at how to navigate the inheritance tax paperwork maze in nine clear steps in a separate article.
