Sanity restored? The impact of the pension changes on the reduced rate of inheritance tax

It was never going to be a topic that found its way into the Chancellor of the Exchequer's Budget speech. In fact, it didn’t even make it into the 166-page Budget Report. But, buried deep in the OOTLAR (which you would be forgiven for not knowing stands for HMRC's post-Budget "Overview of Tax Legislation and Rates"), we learned of a tweak to how the upcoming pension changes will impact the reduced rate of inheritance tax (IHT) for charitable estates. It will be of significant interest to charity legacy teams. Find out more about the reduced rate of inheritance tax.

Why pension property created concern

Given that the calculations for the reduced rate of IHT have always been component-based (i.e. with separate components for the general estate, survivorship property, and settled property), it seemed obvious that the pensions changes would lead to a new component, i.e. a notional pension property component. 

But no, the original announcement by HMRC, made via one of its technical notes, was that pension property would form part of the general component. One of the chief characteristics of the general component is that it comprises the estate that passes via the will or intestacy. It therefore felt odd for pension property to be included, as, despite the upcoming changes, that property still passes outside of the estate, usually at the discretion of pension trustees.

The risk to charitable legacy gifts

This could have had unintended consequences. Take a scenario where the testator made a will including a gift to charities aimed at securing the reduced rate of IHT by way of STEP's model clause. Unless the will was made very recently, the testator would likely not have known that their unused pension funds and death benefits might fall into the calculation for the reduced rate. The result, in this hypothetical, would be to increase the size of the general component. As the STEP model clause is designed to ensure that the reduced rate is secured, it would operate to increase the amount passing to charities via the will to ensure that the 10% baseline test is met across the component as a whole, and possibly by a great deal given how large unused pension funds and death benefits can be. This might be at odds with what the testator intended. A theoretical enhancement to legacy income perhaps, but not in a way that charities would want, as they naturally only want to receive what testators genuinely wanted them to have. Just how much that is could have been left uncertain, possibly leading to disputes and even litigation.

But it seems we need not worry about this anymore, as the change announced via the Budget was to bring about what many thought should have been the case in the first place, i.e. there will be a separate component for pension property after all. Or at least, that is how we have interpreted the relevant section of the OOTLAR, which says:

"The government will also introduce legislation allowing those administering an estate to decide whether notional pension property [is] included in the ‘general’ component of the estate or as a separate component for the purposes of calculating the reduced rate of inheritance tax when part of the estate is left to charity."

That is the only comment that has been released by HMRC for now, and, as ever, we will have to wait for the legislation before we can be certain of how the change will operate. However, the snippet strongly suggests that a new component will be introduced for pension property. As those who have wrestled with the technical detail of the reduced rate will know, personal representatives have always had the ability to elect to merge components (subject to meeting certain requirements), which can bring about a tax-efficient result in certain circumstances. The reference to "allowing those administering an estate to decide" would therefore suggest that pension property will be a component of its own, and that the ability to elect to merge components will remain.

A welcome development for charities and advisers

We understand that advisers involved in wills & estate planning have, perfectly sensibly, been encouraging testators to tread carefully with any charitable giving aimed at securing the reduced rate of IHT, and in some cases have been cautioning against the use of the STEP model clause due to the risks involved with pension property forming part of the general component. We trust that the change announced at the Budget will restore faith in the model clause as a potential tool for tax-efficient giving, to be discussed with testators as part of their overall plans. The clause has stood the test of time since the inception of the reduced rate in 2012 and has been a mechanism through which tens (if not hundreds) of millions in legacy income have passed to charities, all while securing a benefit to estates as a whole by way of mitigation of IHT. 

Now of course, this topic is only one very small part of the upcoming pensions and IHT changes. Please do look out for the first of our 2027 Lunch & Learn series in conjunction with the Institute of Legacy Management, which we expect to take place in March 2027, i.e. roughly a month before the changes come into effect on 6 April 2027. We've intentionally left it quite late because, as neatly illustrated by this article, we are, to this day, still seeing changes and updates to the technical detail, and we hope (but cannot promise!) that, by March 2027, we will be able to talk to charity legacy teams about the "final" position.