The Autumn Budget: an unintended boost for defined benefit schemes

Changes to inheritance tax in the Autumn Budget could end up making defined benefit pension schemes more attractive to savers, but work is needed to make them more attractive to employers.

The 2024 Autumn Budget will bring significant changes to inheritance tax (IHT). The Chancellor of the Exchequer, Rachel Reeves, plans to make most pension and death benefits liable to IHT from April 2027, raising concerns about double taxation.

These changes align the treatment of pensions with the treatment of other assets, such as property, savings and investments. When passed on, these are subject to IHT at 40% if they are above the ‘nil-rate band’ (the amount that can be passed on without being subject to IHT). The nil-rate band is £325,000, rising to £500,000 if it includes the person’s primary residence (for estates that include the primary residence, the nil-rate band falls by £1 for every £2 above £2m).

IHT is subject to several exemptions. For example, sums passed to a spouse, or a civil partner, are exempt from IHT.

How inherited pension benefits are currently taxed

If an estate is left to someone who is not a spouse or civil partner, benefits from registered pension schemes are typically excluded when working out the total value of an estate for IHT purposes.

A different tax regime applies to pensions; the details depend on the nature of the benefits payable and how old the pension scheme member is when they die. Dependants’ pensions such as those payable by defined benefit (DB) schemes are taxed as income. For death benefits from defined contribution (DC) arrangements, the position is:

• If the member dies before age 75, death benefits are paid tax-free regardless of how those benefits are taken (as income or lump sum).
• If the member dies at 75 or older, for death benefits taken as income, the inheritor pays income tax at his or her personal tax rate. For death benefits taken as a lump sum, tax is payable at 45%.

What’s changing?

Under the new regime, unused DC funds and non-insured lump sum death benefits in DB schemes will be subject to IHT. Savers will therefore have less opportunity to use pensions for IHT planning.

With the new regime, there is potential for double taxation for people older than 75. Their beneficiaries could have to pay IHT in addition to paying income tax at their marginal rate on pension benefits received. For dependants in a 40% tax band, this would result in an effective tax rate of around 64% – for the wealthiest families, this could be as high as 90%.

One simple approach to reducing the tax burden is to spend more in retirement while you’re alive – which will be appealing to many. However, overspending comes with risks. If retirees live longer than expected, they could be left with inadequate pension assets. This risk forces individuals to walk a fine line between overspending and passing on funds at a higher tax rate.

Unintended upsides for DB pensions

Under the new regime, DB spouse and dependant pensions will not be subject to IHT. So, DB pensions become a more attractive vehicle for passing on wealth to the next generation, compared with DC retirement income.

People with DB pensions can spend confidently, without the fear of running out of money. They can pass on their wealth tax efficiently, through spouse or dependant pensions and DB schemes could externally insure lump sum death benefits, to keep them out of the scope of IHT.

These changes are less likely to affect members of DB schemes that are open to accrual. A saver with the option of contributing more towards a DB pension could still take advantage of IHT rules to plan tax-efficient wealth transfer.

The changes may end up creating an unexpected opportunity for saving structures with a DB element. For example, an employer could offer a hybrid scheme with a DC pot that can partly be used to buy a DB pension at retirement. A member could choose the amount of pension to buy and whether to include a spouse or dependant pension, so they can strike a balance between guaranteed income, flexibility, protection and efficient wealth transfer.

Can we really bring DB back?

So far, the IHT changes appear to be positive news for a DB renaissance. However, with DB comes risk that the sponsor has to absorb – there is no doubt that DB schemes carry more risk to the sponsor than alternative DC arrangements.

Even though the government has given DB a perhaps unintended boost through the new IHT regime, without sponsor appetite, DB is unlikely to make a comeback. To improve sponsor appetite, the government needs to make surplus sharing between employers and members more attractive and easier, so a DB scheme can become an asset for a sponsor. We think DB schemes should be about reward as well as risk.

The Pensions Regulator (TPR) should set an enhanced objective of improving pensions for workers. A change in TPR’s mandate would give employers and the pensions industry freedom to innovate and provide new saving designs (such as hybrid DB-DC arrangements). These would give DB schemes a longer-term investment horizon and open the door to investing in more productive assets, securing higher pensions and reducing the cost of sponsoring DB schemes. For more on this, see our paper A Pensions Plan for the new Government.

Carried out carefully and with a long-term view, these changes could move the dial on the risks associated with DB and help improve sponsor appetite.

Time for a DB resurgence?

The 2024 Autumn Budget presents challenges, but also brings opportunities for DB pensions to shine. By focusing on spending confidence, wealth transfer and tax efficiencies, DB pensions could play a pivotal role in shaping retirement strategies for the future – so long as sponsors change their view on the risks associated with them. UK DB schemes hold £1.2trn, and demand for innovative retirement solutions is growing, so the potential for a DB resurgence is both timely and promising.

If you have any questions, or you'd like to discuss further, please get in touch.