This is fine and there are many options, as I have suggested from time to time in this column.

The only problem is that many people are under the misconception that the residual fund can be passed to their children. So here's a little cameo in an attempt to illustrate one angle to this knotty problem.

Imagine a dinner party where the conversation revolves around retirement. One guest pipes up with: "The problem with pensions is that if the Government does not take back your fund, the insurance companies will."

They go on: "I will be 75 in a few months time and I have one of those self-invested things. I'm told that if I keep it invested most of it goes in tax when I die or, alternatively, I have to buy an annuity and the insurance company gets it. I wanted my family to get any money that was left."

A not unfamiliar sentiment, you will probably agree. The guest happens to be a doctor with an NHS pension, whose other pension fund is not really required to maintain his lifestyle, which is why he is naturally keen to pass it on to his children.

As he rightly stated, if he goes for the Alternatively Secured Pension (ASP) — aptly named in my view, as it has a sting in the tail — then, when he dies and/or his spouse dies, 82% of the fund — or more in some cases — will be subject to tax, leaving a pittance for the next generation.

So what, if anything, might he do about this?

If we assume he has £100,000 in his fund, he would be wise to take the tax-free sum — or pension commencement payment as it is now called.

This could then be put into one of the many inheritance tax-efficient vehicles available.

But what about the remaining £75,000? If he buys an annuity he effectively loses the fund. If he chooses ASP the income is set between 90% and 55% of a single life annuity based on the rates at the age of 75.

So he is facing a difficult choice. But suppose he buys an annuity and reinvests the net income into a whole-of-life policy, which would pay out on second death?

The children would then be left with a lump sum outside the estate and free from inheritance tax. There is one other important consideration here and that is what type of annuity to buy.

There are many types, from the ordinary guaranteed, to with profits, investment linked and the newer, flexible types.

I do not have the space to go into all the rates here, but suffice it to say that you will tend to get higher payments with flexible annuities, simply because the annuity is bought for a shorter period (generally five years) and then re-bought for another, and so on.

But what if our guest cannot get life cover because of a health condition? Then he has two choices, both of which are inheritance tax efficient:

l He could buy Alternative Investment Market (AIM) shares, which are free from inheritance tax after two years

l He could buy a pension for each child (although the maximum he can put in is £3,600 per annum)

His choice would depend on whether he wants to leave a lump sum on his death, or provide longer term benefits for his children.

In any event, this whole area has become one into which most people would be wise to invest some serious, lateral thinking. There are also other options, which I will cover on a future occasion.

Nicholas Watts is an independent financial adviser with Positive Solutions Financial Services which is regulated by the Financial Services Authority. To contact him, use the website www.realwealthmanagers.co.uk.