How do we minimise our IHT risk?

Andrew and Suzanne are 75 and 71, respectively. They have around £1.1m across a Sipp, Isas and dealing accounts, with an additional £100,000 in cash. Their house is worth £800,000 and Suzanne has a pension that pays out around £20,000 a year. They both intend to start taking their state pensions in four to five years, when their expected combined value should be around £35,000 a year. They have no mortgage or other debt.

They have restarted taking holidays and expect to have an annual income shortfall of £10,000 for three and a half years that they intend to finance from cash.

"We have two children, who each have two children. Our aim is to live off our income and in time both hand on our wealth to them and also minimise inheritance tax (IHT)," Andrew says. "We take out the natural yield (around 3.25 per cent) from the very large number of different shares we own (116 holdings in all) to live on, along with my wife’s pension.

"We aim to keep our combined income below higher-rate taxation. Our principal concern is if we were both to require simultaneous nursing home costs at some time in the future. If this happened, we would purchase 'immediate needs' annuities, funded by cash, and, if necessary, from our Isas.

"In five years' time, we intend to gift 50 per cent of our house to our children, continue to live in it, but pay them 50 per cent of its commercial rent. We will use a proportion of our state pensions to pay them the rent.

"In the 50 years I have been investing, I have lived through the 1970s crash, the 1980 crash, the 1987 crash, the 2000 dotcom crash, the 2008 financial crash and the pandemic crash. I have little faith in the UK economy and therefore invest a significant proportion in well-managed, UK-based, international companies, which will also benefit if sterling falls in the long run.

"Some of these stock market crashes were [falls of] up to 50 per cent. Normally, in a crash, the income that shares generate does not fall as far as their capital values. I am therefore not concerned at the prospect of a crash, even if it was over 50 per cent. It sometimes represents a buying opportunity and can reduce any potential IHT. The market would eventually recover anyway – it always does!

"The vast majority of our holdings are income-producing shares. They are also bought for long-term growth. I believe in the 'buy and hold' strategy, with the ideal holding time of 'forever'. Sooner or later, inflation will return. Equity investment provides the safety net. We do not, and will not in the future, take out capital from our investments.

"Where possible, our strategy also involves not wasting money on 'expert' annual fees from active fund managers. We also keep dealing costs to a minimum by seldom trading. Normally we only buy shares when companies we have shareholdings in have been taken over or have returned capital to their shareholders. We have limited exposure to property with the exception of our house.

"I believe my strategy in holding a very large number of different shares has been totally vindicated. It is now accepted that the British market is substantially undervalued.  Many of the excellent companies we hold shares in will become subject to takeovers. It is a little like when building societies started to demutualise. The sensible thing then was to open accounts in as many as possible!"

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THIS INVESTOR'S CIRCUMSTANCES.

Chris Dillow, Investors' Chronicle's economist, says:

You own more individual stocks than any retail investor I’ve seen. Your defence of this is interesting – that some will enjoy big jumps as they become takeover targets.

I’m not sure about this. You’re not the only investor looking for takeover targets – so are others, which means that you’ll lose on those stocks that don’t receive bids as the bid premia fade away. It’s not clear that big wins on a few takeover targets will offset these disappointments. In this sense, looking for takeover targets is very different from looking for building society demutalisations in the 1990s: you didn’t lose money by betting on the wrong demutualisation, but you can by betting on the wrong takeover targets.

Your claim that nobody can predict the targets is also interesting. Acquirers don’t buy companies at random. Listed companies are looking for some kinds of synergies. And private equity firms are looking for companies with strong cash flows (so they can take on higher debt) and the potential to be better managed; there’s an inconsistency between holding holdings you believe to be well-managed and buying takeover targets. If you must try to spot such targets (and personally I wouldn’t) try a less scattergun approach.

I doubt that anybody can monitor 116 holdings well. In holding so many stocks there is a danger that you hold onto some bad ones. In fact, a recent paper by the University of Chicago’s Alex Imas and colleagues shows that professional investors do just this: in paying more attention to potential buys, they don’t sell when they should. Remember that good investment performance is about selling as well as buying.

There’s an interesting contrast between how much you are diversified across UK companies and how little diversified you are internationally. This is odd because I think you are right to look for international companies that would benefit from a fall in sterling. Surely, though, a better way to do this would be via overseas companies rather than UK ones – and you can get exposure to these through tracker funds.

Granted, as a value investor you might not fancy the US market much now. But what about European or Japanese trackers? I’d have thought that these would be worth considering by anybody with little faith in the UK economy.

Nor am I as confident as you that equities are a safety net against inflation. Yes, they do well if inflation (and inflation expectations) rise because the economy strengthens. But it is very possible that higher inflation will be accompanied by fears of higher interest rates. In this case, shares might not do so well – although nor would bonds or even gold. Strange as it might seem, cash might be better protection: its maximum loss is the real interest rate, which is less than the worst-case losses on other assets.

Ordinarily, I would also quibble with your claim that the market always does recover from losses. For one thing, as Will Goetzmann and Philippe Jorion have shown, many of the stock markets that have existed historically have suffered permanent losses. And for another, as I write this the FTSE 100 is lower than it was at its peak 21 years ago and the Japanese market lower than it was in 1989.

You might, however, reasonably discount these counter-examples. Some are the product of serious political disturbances and others the legacy of overvaluation, neither of which are perhaps relevant now. But they might become so in the future.

Kirsty Simpson, financial planner at Brewin Dolphin, says:

You currently have an income shortfall of £10,000 a year. That said, you could start to draw on your state pensions and plug this gap easily. Although an increase of 10.4 per cent [on deferred state pensions] sounds like a good deal, if you were to pass away you will have had no benefit of this pension income. I would draw both of your state pensions now and have the capital in your pocket to enjoy and spend on holidays. If you were to take the state pensions in April 2022 the income paid will cover the shortfall and give you roughly a further £10,000 as well. If you draw the income now, by April 2026 you will have received around £100,000 as an income stream. If you start to draw your state pensions in 2025 and 2026 it will take you a number of years to receive the same capital sum as if you had started them in April 2022 – you will then be into your 80s. 

You have an inheritance tax liability; in five years’ time you are planning to gift away 50 per cent of your home to mitigate this. For this planning to work you will need to survive a further seven years, which takes you to age 87 and 83. You could look at other inheritance tax mitigation solutions now rather than wait five years. Some of the other options include using your existing capital and leaving your home in place, with no need for you to pay a rental income. These other options could reduce the current inheritance tax liability to nil in two or seven years. This is quicker than your existing plan of waiting five years to gift the property and a further seven years for that planning to work. 

If you start to draw the state pension and continue to receive an income from your investments, you could turn your Sipp income off.  This would then allow your Sipp to increase in value with the returns being reinvested. By doing this you could increase the value of your pension assets that are outside of your estate for inheritance tax. You should check that your pension is outside your inheritance taxable estate – some older pensions are inside estates and will form part of your liability on death.

If care home fees were required, you could call on your cash and shares to purchase an 'immediate needs' annuity (if suitable) and then as a last port of call draw on the Sipp. 

Within the portfolio there are more than 100 holdings and, while diversification is crucial, a more concentrated approach can lead to better longer-term returns if appropriate diversification is maintained; as well as the practical benefit of being able to conduct thorough and ongoing due diligence. Diversification should take place not only across companies, but also across regions and asset classes (equities, alternatives and even bonds). While you hold numerous different direct equities and many with a global reach, there is still a high concentration to UK equities specifically.

You mention that you view the UK as undervalued and you have seen pleasing performance, however there are some fantastic returns to be had overseas which offer further upside while also lowering the overall downside risk; it would still be possible to maintain a UK bias if preferred.