This week, I start to look at the fundamental use of trusts in financial planning recommendations.
To set the scene for the technical depth of the discussion over the next few weeks, I would like to stress that I will be concentrating on aspects of the use of trusts which should be commonplace in the majority of financial planning recommendations produced by financial advisers and, in particular, independent financial advisers – not the more detailed, technical and creative use of trusts.
This latter area of our business is far better dealt with by Tony Wickenden and Technical Connection, as featured elsewhere in this publication and I would not even dare to attempt to add or improve on those articles.
Instead, I want to identify and examine the ways in which we should be widely recommending the practical use of trusts for clients in all sorts of circumstances and, in particular, with regard to all sorts of financial planning products.
Nowhere can this series of articles be more readily and universally applied than in connection with protection policies. So in this introductory article I will start to examine why there may be great cause for concern that many or most protection policies are effected without any real consideration of a trust.
In other words, what is the justification for the view that these policies in particular, and other policies and financial services products in general, should always be effected under some sort of a trust unless there is very good reason why this should not happen.
So, starting with protection policies, the main purpose of effecting these policies in trust is (as my earliest training kept glibly but forcibly drilling in to me) to ensure that we ensured that the policy provided “the right money in the right hands at the right time”.
Simply, this meant that we would ensure that the sum assured within the policy was appropriate to the client's needs (right money) would be paid to the person or people identified at outset by the client – we will take it that the client is also to be the life assured in this scenario – as being those in need of the money in the event of his or her death (right people) and would be paid on the happening of a particular event – usually death – promptly and without fuss (right time).
This useful little one-liner, which we were encouraged to quote to clients as being easily understandable, highlights most of the main reasons for effecting a trust.
To apply this right money, right hands, right time phrase to protection policies means first of all – right money – that an appropriate sum assured is selected and that this death benefit payment will not, wherever possible, be tainted by an attack by the Inland Revenue identifying some form of taxation liability.
The correct sum assured will depend, of course, on the purpose of the policy. The attack by the Inland Revenue can most obviously be identified as being the potential inheritance tax liability on the sum assured if that payment falls into the deceased's estate – if we assume the life assured is also the policyholder.
This is a crucial but unfortunately often overlooked issue. If such a policy is not effected under a trust, then the death benefits will fall into the deceased's estate. If the value of that estate is already greater than the inheritance tax threshold or becomes greater due to the payment of this death benefit, then an IHT liability will arise on this sum assured. This is avoidable by the simple use of a straightforward trust such as those provided by most life companies.
Now, you may be thinking this point should go without saying, but I can assure you if you ask any insurance company the percentage of protection policies which are effected without the use of a trust they will become horribly defensive as they are aware that the percentage is indefensibly low.
I say “indefensibly low” as I would contend that the start point for advice is that all protection policies should be written in trust unless there is a good reason not to, in contrast to the usual feeling that policies should only be written in trust if there is a good reason to do so.
Exceptions may include policies effected on a life of another or a joint-life basis, although even here the use of trusts will usually be effective.
Not that this arguably negligent practice is the fault of the product providers, of course. That is, unless their business comes from company representatives, direct salesforces or direct advertising.
Now, the thoughts about the use of trusts from that last distribution channel is a fair old topic for discussion, isn't it?
So, some innocent punter hears – perhaps from some well-meaning consumer-focused publication or group – that term insurance is so simple and uncomplicated that they should simply shop around for the cheapest rate, which will almost certainly be found from off-the-page or internet advertising.
The punter, calculating his required sum assured as being the lump sum he wants to leave to ensure his dependent children can enjoy sufficient income after his death to maintain their lifestyle, finds a cheap rate off the page and effects the policy for a sum assured of, say, £400,000.
He then dies. The children are paid the £400,000 but, because their parent's other assets already exceed the IHT threshold, they find they have to pay £160,000 IHT.
In effect, 40 per cent of the premiums paid by the deceased have therefore been wasted. This is all the worse where the policy is effected for the purpose of providing a fund for the children to pay an IHT liability on the deceased's other estate, as follows:
1: Client calculates IHT liability on his estate to be £400,000. He effects a life policy, not in trust,for this amount.
2: Client dies. £400,000 becomes payable. IHT liability £160,000.
3: In anticipation of 2,the client, before his death, effects a policy to pay the extra IHT liability on policy proceeds £64,000
4: In anticipation of IHT liability on 3, the client effects a further policy £25,600
Ridiculous, isn't it?
The thoroughly and obviously contrived example above would not happen in practice, of course, but nor would the client be given any advice or guidance on the use of a trust from the direct advertiser or marketer.
This oversight in many cases results in a needless tax charge of 40 per cent on the death benefits, equating to a 40 per cent waste in premiums.
This waste does not obviously occur where the death benefit payment would be made to the deceased's spouse, but even here the constructive and mildly imaginative use of trusts can save broadly a similar amount of IHT on the spouse's death, as we will discuss in a later article.
It is tempting to bring this negligent practice to the attention of consumer-focused groups but perhaps this could best be done where and when we are confident that we ourselves could not be accused of the same malpractice.
Unfortunately, far too many protection policies are written without thought to a trust – not only from direct marketing but also from company representatives and IFAs.
Without doubt, in my mind, this is an issue which we need to address immediately to ensure all financial services products – not just protection policies – are written in an appropriate trust unless the omission of such usage can be justified.
Therefore, in this series of articles I will be develop-ing from first principles (which, though on the face of it basic, include a number of important principles and concepts) through to more advanced but still widely practical use of specific trusts and trust wording.
My thanks go to the excellent seminars and training events by Tony Wickenden and John Woolley of Technical Connection for many of the concepts and ideas for these articles.