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How do we minimise our IHT risk?

This investor wants to maintain an income while gradually passing assets to his family
How do we minimise our IHT risk?
  • This couple currently lives off a pension and income from a portfolio of shares
  • They wish to pass on wealth over time – including gifting half of their property to their children in five years' time
  • They are wary of tax liabilities, and potential care costs
Reader Portfolio
Andrew and his wife Suzanne 75 and 71
Description

Isa, pension and dealing account invested mainly in stocks, residential property, cash

Objectives

Live off portfolio income and a pension for now, and pass on assets over time while minimising any inheritance tax bill

Portfolio type
Inheritance planning

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!"

 

Andrew and Suzanne's full portfolio (excluding cash)
HoldingValue in £% of portfolio
CRH (CRH)989378.827725645
Porvair (PRV)402563.591870823
Experian (EXPN)390603.485156854
Futura Medical (FUM)321562.869142443
Fidelity Global Enhanced Income (GB00BKDZ1K85)298462.663031016
Unilever (ULVR)264052.356005293
Diageo (DGE)257152.294439542
NatWest Group (NWG)235432.100641265
H&T (HAT)227262.027743847
IBM (US:IBM)213761.907289117
Weir Group (WEIR)213551.905415377
Legal & General (LGEN)212791.898634222
Abrdn (ABDN)209261.867137541
Prudential (PRU)207861.854645939
Reckitt Benckiser (RKT)187471.672714684
Hill and Smith (HILS)187091.669324106
Spirax-Sarco Engineering (SPX)178411.591876176
Dignity (DTY)175861.569123616
Fidelity European (GB00BD7XZ185)168931.507290188
Johnson Matthey (JMAT)165431.476061184
Fidelity Asia Dividend (GB00B8W5M023)163171.45589617
AG Barr163071.455003913
Vodafone156641.397631771
Verizon156301.394598096
GlaxoSmithKline154391.377555982
Standard Chartered154061.374611533
BHP150481.342668724
Dunelm146811.309922882
Speedyhire136941.221857091
Croda International131121.169927718
Begbie Traynor130651.165734109
Rio Tinto128811.149316576
Strix126361.127456273
Sage118991.061696913
Rotork118681.058930915
HSBC114741.023775979
Invesco Asian113041.008607606
SSE106870.953555333
MacFarlane Group103830.926430712
Henderson Far East103770.925895358
TT Electronics99030.883602364
Barratt Developments95420.851391877
Aviva94870.846484462
Halfords94330.841666273
Lloyds 9.25 Preference94200.840506338
3i Group (iii)89360.797321087
Standard Life Investments Income87490.780635876
Invesco UK Smaller Companies86410.770999498
Bellway84520.754135835
Pearson84410.753154352
Tesco83470.744767134
IMI82570.736736819
Ferguson82190.733346241
Royal Dutch Shell79630.710504455
Elementis79240.707024652
Close Brothers77650.692837762
Invesco Japan66920.597098558
MJ Gleeson63640.56783252
Lloyds61970.552931824
BlackRock58570.522595077
Hargreaves Lansdown55870.498504131
Relx55630.496362713
Janus Henderson Global54060.482354274
PZ Cussins52670.469951898
XPS Pensions51760.461832357
Invesco Income Growth50620.451660625
Invesco High Income50190.447823918
Kingfisher43590.388934939
Savills42540.379566238
Co-Op Group 11%42530.379477012
Hays40540.361721093
Entain39900.356010646
M&G37920.338343953
Topps Tiles36360.324424739
Carrs Group34940.311754686
Provident Financial34220.305330434
RSA Insurance Group33830.301850631
London Metric Property33790.301493728
AstraZeneca33170.295961733
Meggit33040.294801798
BT32980.294266444
Fidelity MoneyBuilder Income31770.283470131
Admiral30350.270800078
Thomson Reuters30240.269818595
Morgan Advanced Materials30070.268301758
Contour Global29020.258933057
WM Morrison23500.209680456
Paypoint22800.203434655
Nationwide 6.25%21450.191389182
Balfour Beattie20970.187106347
Natwest 9% Preference20090.179254483
Vianet19860.177202292
Inchcape17970.160338629
Hargreaves Service16800.14989922
Fresnillo16210.144634902
Sutton Harbour16070.143385742
BP16060.143296516
TalkTalk14280.127414337
Schneider12730.113584349
Checkit11230.10020049
South 3211040.098505201
Dixons Carphone9860.087976566
Ricardo9660.086192051
Rolls Royce7660.068346906
Rank7550.067365423
Melrose6420.057282916
International Personal Finance6370.056836787
Etfs Ag4710.042025317
M&S4660.041579188
Indivior4500.040151577
Liberty Global A class3720.03319197
Foresight 3190.028463007
Oryx International2830.02525088
Liberty Global C class1560.013919213
Tanfield520.004639738
Liberty Latin America200.001784515
Total1120753100

 

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.