Consumers need to feel they can rely on their insurance policies paying out. David Ingram explains why they should put their trust in life assurance by putting their policies in trust
Clients who take out life assurance and critical illness (CI) plans generally do so because they have a specific need in mind such as paying off a mortgage or other debt, in which case the policy will pretty much be compulsory with little flexibility in how it is written. Other reasons include school fees planning, provision of income for surviving family members, creating a degree of wealth for the next generation and paying Inheritance Tax (IHT).
These clients want certainty around their selected policy. They want to be sure it will pay out when the time comes - and that is very much an issue when the IFA considers the financial strength of the provider, examines policy definitions, ensures there is no non-disclosure (or at least makes sure the client is aware of its consequences) and makes sure premiums are affordable for the foreseeable future.
But, if advisers dig further, they may discover clients want more than this.
They could want confirmation that payment will be made as soon as possible and not held up by probate applications. They may want to know the full sum assured will be paid to their intended beneficiary without the tax man intervening. And they may want to know that no other potential beneficiaries will be able to challenge the arrangement to try to get a slice of the benefit for themselves.
In short, they want their policy to be set up in trust so the right amount can be paid to the right people at the right time.
Trusts have had some bad press since the unexpected changes introduced in the 2006 Budget with new complications and potential tax charges brought in. These changes, however, mainly affect lump sum IHT avoidance schemes and the vast majority of regular premium protection plans are unaffected. But even before 2006, the majority of life assurance policies were not written in trust. Estimates vary but somewhere around 95% of term policies are not set up this way.
This is despite the benefits they offer and regardless of the risk of legal action from beneficiaries who are disadvantaged by the policy not being in trust.
Advisers have a full range of trusts available to them: Absolute or bare trusts, including married women's policies of assurance trust and its various UK variants; flexible or power of appointment trusts; discretionary trusts; and accumulation and maintenance trusts. Plus, of course, split trusts still exist so add-on CI cover can be held for the benefit of the life assured rather than being paid to the trust beneficiaries.
Premium payments for protection policies are often exempt from IHT under the annual £3,000 or normal expenditure exemption, so many of the complexities of the taxation of trusts do not apply.
The table below shows the incidence of IHT on the various trust types, all of which are usually available in draft form from the life assurance companies. They tend to provide excellent draft trust deeds, including deeds which can be used to place existing policies in trust, although it is good advice to suggest to the policyholder that they consider seeking legal advice on the suitability of the wording for their specific circumstances.
Although regular premium policies avoid many IHT issues, there area number of complications to consider.
Firstly, the premium may be low enough to avoid complications but the sum assured may be taxable under the 'exit charge' rules if a trust other than an absolute trust has been used.
Assuming the life assured has not made any chargeable lifetime transfers for IHT purposes in the seven years before setting up the policy trust - which would include any potentially exempt transfers that became chargeable as a result of their death - the trust should have its own nil rate band of £312,000. If the sum assured is above this level the excess may be subject to IHT at a rate of up to 6%.
It may be that no tax would apply because the rate of it is determined by what was in force when the premiums were paid - and these may have been exempt - or at the last 10-year anniversary of the trust. The 10-year anniversary periodic tax charge is based on the market rate of the trust's assets at that time. Life policies accrue value slowly as the bulk of the premium is used to buy life cover, so this is seldom a problem unless the life assured is in ill health at the time of the valuation - it is the market value and not the cash value which is used for this purpose.
Softening the blow
The risk of a tax charge can be minimised by creating a number of different policies so no trust has a policy exceeding the nil rate band. It can be removed altogether if an absolute trust is used; in which case the lack of flexibility needs to be balanced against the IHT benefits.
This is a complex issue. However, not using a trust at all would result in the risk that the whole sum assured could be taxed at 40%. Failing to use a trust could mean a client with no IHT problem when the policy was taken out actually dies with an estate in excess of the nil rate band due to the inclusion of the sum assured.
It is important to select the right trusts for clients. It is also crucial that the right people are selected as trustees to act with them. Generally it is not considered appropriate for a client's financial adviser to act as trustee due to any conflict of interests. With flexible and discretionary trusts it is usual to have more than one additional trustee to ensure no single beneficiary has the power to appoint the whole benefit to themselves. It makes sense to look for trustees who are in the same age bracket as the life assured, or at least are not significantly older and therefore at risk of dying before the life assured. Obviously the client has to make this selection but, especially since additional trustees need to sign the deed that appoints them, the adviser will often meet them to explain the function of the trustee and the purpose behind the trust, often highlighting a protection need of the trustee.
Asking for trouble
We live and work in litigious times. A beneficiary who sees a significant part of their expected inheritance disappearing in the direction of the Treasury when that could have been avoided by the use of a simple document can be expected to sue and would stand a good chance of success.
The delay that the absence of a trust can cause in getting payment to a beneficiary should also not be underestimated. Well-known high street banks have been known to take three months just to produce a written valuation of the life assured's deposit accounts at the date of death. This means payments to beneficiaries cannot be made until this information is received. But writing a life policy in trust allows payment of the sum assured to be made without waiting for probate; so this is another area where an unhappy beneficiary may be able to seek redress against the adviser.
The use of trust around protection policies is good for clients, it is good for their beneficiaries and it is good for advisers.
- David Ingram is partner at threesixty services.
