By Matt Dickens, Senior Business Development Director at Ingenious

Most financial planners and wealth managers will be very familiar with the old maxim, “you should never let the tax tail wag the investment dog”, meaning that one shouldn’t chase a tax benefit by “compromising on either investment performance or risk level”. But what if the client’s specific stated objective is to access a particular tax benefit?

An area where this question is especially pertinent is in delivering proactive estate planning. The objective of all estate planning is to ensure the maximum legacy is transferred to the client’s chosen beneficiaries. The best financial “outcome” is decided by two principal factors; firstly, the size of estate to start with and secondly, what any reduction, due to principally inheritance tax (IHT), will be. Clearly if an estate plan can both deliver significant capital growth during the client’s lifetime (or on their death) and also ensure it will reduce, or even better eliminate, the impact of IHT, then this plan will be most suitable to achieving the client’s stated objective. Hence, we should primarily assess and select the most appropriate solutions for clients based on how well they achieve these twin goals.

Whilst it’s the case that all estate planning techniques attempt to improve the outcome in at least one of these areas, sometimes these goals can appear mutually exclusive. For example, whilst life insurance can be put in place to generate an extra capital pay-out on the death of the client, it doesn’t actually reduce the IHT liability on the existing estate; it can only help counter the effect of it. So, it can help achieve the first goal, but doesn’t address the second. Equally, the simple gifting away of assets may in time become IHT-effective, but once a gift is made no further growth will be created for the client. Thus, the opposite case is true.

So ideally, they should address both aims and to that end some trust-based plans can deliver to an extent on both, allowing a client to simultaneously make gifts that may in time become fully IHT-effective whilst still providing some investment growth. The reason that they only “may” become fully IHT-effective is that this won’t be the case if the client dies within the first seven years. This should be a major consideration for the typical cohort looking to conduct proactive estate planning. On top of that, these plans are typically irreversible, can prove somewhat inflexible and are subject to certain limits on how much can be contributed without immediate tax charges arising or, if it is allowed, how much can be withdrawn in any year. Some plans also require full medical assessments and individual underwriting to be carried out, which is off-putting for some and excludes even more.

For that reason, investing in IHT-effective investments, primarily through the use of Business Relief (BR) qualifying investments, has grown in popularity over the last 15 years, as it allows any client to conduct proactive estate planning and deliver on both those aims without making any irreversible or inflexible decisions. An unlimited amount can be invested at any time into a BR-qualifying service and the investment typically will become IHT-effective after just two years which obviously compares well with any seven-year effective strategy. Clients also benefit from retaining full control and access to their investment should it be needed in future for any purpose, rather than having to gift it away forever.

However, even these BR-based services have one commonly overlooked planning risk. The simple fact is that for the clients who have to hold these investment plans for two years before they become IHT-effective, there is the critical risk of death within that two year period. This risk is common across all AIM and non-AIM (unlisted) BR investment services and cannot be “diversified” away. Established BR managers will know this eventuality is an all too common occurrence and renders their plans wholly ineffective. Some managers even agree to repay some initial fees when this happens. But of course the impact of a potential 40% IHT charge will be far greater, “foreseeable harm to clients” will have been caused and a “good outcome” will definitively not have been achieved.

However, on the basis that a two-year fully effective IHT strategy was still faster than a seven-year one, for years advisers were willing to take on the mortality, financial planning and reputational risk of these plans failing on the basis there was no real alternative when investing. Yes, they could purchase either stand-alone life cover for those first two years (assuming the client wanted to be underwritten) or opt to pay for the extra “bolt-on” life cover that some BR services started to offer, but most were put off by the considerable extra fees that would need to pay. As a result, many took the view that paying up to an extra 13% up front was just an “immediate IHT charge under another name” and were happy to overlook and accept the risk despite its potentially ruinous impact. However, this was hardly ideal.

What the market really needed was the ability to fully mitigate this two-year mortality and financial planning risk to ensure advisers would be delivering “good outcomes” to their clients whenever those clients were to die without impacting the returns of the solution.

To support this view, a survey* Ingenious, the investment manager, conducted during 2022 with PFS members showed that 73% of active estate planning and later life advisers thought that a BR-based investment service with life insurance built in would be “the ideal estate planning solution to offer clients.” Built-in life cover, at no extra cost, would allow there to be no negative impact on the investment performance of the service, so deliver on the first key principal factor yet crucially delivering full IHT-efficacy from day one of the investment and so also fully covering the second.

So, by allowing advisers to deliver “the ideal” estate plans to their clients, would this ideal service really be a case of “the tax tail wagging the investment dog”?

Well, we can now see that when considering this we need to assess the relative size and importance of the tail in comparison with the size of the dog. Particularly in the case of proactive estate planning, where the tail represents one of the two principal outcomes, it is only logical to ensure that its needs are given equal weighting particularly when it isn’t notably “compromising on either investment performance or risk level” and is in fact palpably reducing the risk of the plan.