Although the usual drivers for taking out an equity release mortgage have led to well-documented problems, Andy White, Senior Partner at CBW, explains how the much-maligned product can be a useful inheritance tax planning tool
This article was written for and first published in Solicitors Journal.
I once acted for a corporate client that insisted on keeping £200,000 on deposit with the company’s bankers. The reason for this was to provide a sense of financial security as knowing there was always £200,000 in the kitty for a rainy day was conducive to a good night’s sleep.
It wasn’t an easy conversation, but I felt duty bound to point out that running an overdraft of a similar sum, as they were, meant that the security was illusory rather than real. They were good customers of the bank with a terrific covenant so withdrawal of the overdraft facility was not on the horizon. In the meantime, operating the account in this way was costing them considerable sums in terms of the bank’s margin. In short, they were lending the bank its own money and paying a premium for the privilege.
Any observer, financially astute or otherwise, will recognise the company’s error. By focusing on one item, in this case the bank deposit, it lost sight of the overall picture.
So, what has this to do with equity release?
Over the years, there have been many financial products that deserve the epithet ‘much-maligned’, from endowment polices and PPI to interest-rate swaps and pensions. A quick search on Google unleashes a torrent of hits dealing with the mis-selling of these and other products, and much of the opprobrium that has been directed at these products is well deserved. However, a closer examination reveals that the problem is not with the products themselves, but in the way they have been sold.
This was brought into sharp focus for me when a client who had sold his business and retired fell into the clutches of an unscrupulous financial adviser. This individual was entrusted with investing my client’s capital, which was to produce his income and financial security for life. One of the investments the adviser selected was slightly riskier than matched the client’s appetite, but was, nonetheless, a perfectly respectable investment offered by a well-known and reputable provider. The problem was not in the investment, but in the fact that the adviser chose to invest 85 per cent of my client’s funds in the one product. Therefore, when the company got into difficulty and the investment failed, I had to demonstrate to the professional indemnity insurers that it’s possible to mis-sell a perfectly good product because it was not suitable or not suitable with regard to the amount for that particular individual.
A flawed product?
I believe the same can be said of equity release mortgages. Over the years, these mortgages have received a terrible press, the criticisms largely relating to the way they were sold. In most cases, this was due to a lack of clear explanation as to the costs and risks. Perhaps more importantly, the product was often sold to the wrong type of people, but this doesn’t mean that the product itself is inherently flawed or that it does not or cannot have a place in overall financial planning for certain types of individuals.
Much of the criticism has concentrated on horror stories of elderly couples locked into properties which are too big for them, or estates becoming insolvent because of the claims of lenders for disproportionate amounts when compared to the value of the original loan. Leaving aside the fact that most such products now come with a promise of no negative equity, this danger is, of course, the product of the compounding of the interest as well as the fact that the rates of interest are high compared with conventional mortgage products.
Anyone with a ‘normal’ home loan at 1.5 per cent per annum, for instance, is bound to be horrified at the prospect of their parents being quoted nearer 6 per cent for their equity release mortgage. Ignoring the fact that the borrower has limited income, that the rate is fixed for, perhaps, decades, and that the lender may not see any cash for a considerable number of years, they inevitably conclude that anyone charging four times the ‘normal’ rate is ripping off their parents.
With many people holding the view that all companies in the financial services industry are greedy and corrupt, it’s little wonder that equity release mortgages are not flying off the shelves. Although sales have been growing recently and 2016 was a record year, showing a 34 per cent increase on previous years, the numbers are still extremely low. There are around 30,000 of these products sold every year, which may sound like a lot, but in terms of the size of the country’s population, it registers as little more than a rounding difference. This is because, for those individuals needing a boost to their income, most financial advisers would view this solution as the last resort and because of the effect of compound interest described in this article, they would be right to do so.
IHT planning tool
Considering my corporate client with the £200,000 deposit account, how does our criticism of their view relate to the equity release world?
Since the turn of the century, there has been an increasing trend towards ‘family investment’, rather than considering the needs of a particular individual. Advisers frequently consider the family as a single unit and develop strategies to fit the wider family need.
At its simplest level, individuals in the UK have been adopting this approach for years. Gifts to children to avoid inheritance tax (IHT) follow this broad principle. Does the gift leave the donor better off? Of course not. Does it leave the family better off? If it’s successful in mitigating the IHT charge on death, then yes.
And here’s the rub. The company with the £200,000 deposit failed to see the bigger picture, which may be visible to the potential equity release borrower. To take out an equity release mortgage to supplement spending may indeed be a dangerous policy, but what if the money were used as an IHT planning tool? What if the funds raised were given to the next generation for investment? What would be the effect?
Simple analysis reveals some startling results, which are driven by the fact that an individual’s own home is a disaster from an IHT perspective. It’s normally non-income producing yet results in a significant tax liability on death. Not only does an equity release mortgage potentially reduce that liability significantly, but the rolled-up interest even adds to the benefit.
The interest charge is a problem, of course. Compounding 6 per cent p.a. over 15 years, for example, grows a debt to almost 2.4 times its original size. But let’s look at the other side of the coin. If the gift is used as an investment so that the funds also benefit from the effect of compound returns, doesn’t that compensate for the growth in the debt? So, is the family as a whole better off?
In short, yes. Because the investment returns are growing outside the estate, the break-even return required on the investment to match the 6 per cent p.a. equity release charge is less than 1 per cent p.a. Even the most cautious financial adviser would readily accept that challenge.
This is the key to the issue. Borrowing to invest is normally a risky proposition. One has to be certain that the investment returns will comfortably exceed the charges levied by the lender and that is a challenging proposition, particularly in the current market.
Using the strategy outlined here changes the position entirely because the two parts of the plan are not equal and opposite. Whereas the borrowings and the rolled-up interest attract tax relief at 40 per cent, there is no such tax charge in the hands of the next generation. The capital is tax free and while the returns will be subject to income tax or capital gains tax, depending on how the investment is structured, careful planning can easily mitigate the effects.
Since equity release rates are fixed, this analysis is only likely to result in an even rosier picture when interest rates climb in the future, as they inevitably will.
So here is a strategy that involves investing for a higher return than the cost of the funds deployed. I wonder if I can persuade my corporate client to consider it.
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