The best of both worlds
Fixed-term annuities can be an appealing third option for retirees
Most savers reaching retirement believe they have a binary choice to make about how they start taking income from their pension funds. But while most people opt either to buy a lifetime annuity
– paying a guaranteed income until death
– or to draw down income directly from their funds, there is a third option. A fixed-term annuity could be a good compromise option.
Like conventional annuities, fixed-term annuities pay a guaranteed income. But the difference is that you are only signing up for this income for a limited period: five, seven or ten years are common arrangements. At the end of this fixed term you get a guaranteed sum back, with flexibility about how you arrange your finances from then on. You could buy another fixed-term annuity, move to a lifetime annuity, or go into a drawdown arrangement.
This can offer the best of both worlds. You’re not committing yourself to an annuity for good, with the pension fund cash not needed to finance your income remaining invested. But you are getting guaranteed income for a period, and certainty about how much pension fund you’ll have remaining at the end of this term. Income-drawdown plans do not offer this security.
Fixed-term annuities can therefore work really well for savers not ready to commit to a lifetime annuity, but nervous about managing their money in a drawdown plan. You even have the option of taking no income at all during the period of the annuity – and therefore receiving a larger guaranteed maturity value at the end of the term. Alternatively, fixed-term annuities could also be useful for savers facing an income shortfall for a period. Perhaps you’re retiring a number of years before you’re eligible to claim your state pension, for example. A fixed-term annuity could be a good way to bridge the gap.
These arrangements do have potential disadvantages. For example, if annuity rates fall during your fixed term and you’re looking to buy a lifetime annuity at the end of this period, you’ll get less income than you might have been able to purchase by choosing the latter product earlier. Similarly, your guaranteed maturity sum may be lower than the amount of money you’d be able to generate by actively managing your pension fund investments in a drawdown plan. Furthermore, if you do want to get out of a fixedterm annuity early, there will normally be exit fees to pay.
Still, the upside is a combination of greater flexibility and security than other types of retirement arrangement can offer. The plans also work well from an inheritance perspective. Essentially, if you die before the end of the fixed term, any savings you have not taken as income are available to your heirs.
As far as tax is concerned, you’re still entitled to take quarter of your savings upfront as a tax-free cash lump sum. Your fixed-term annuity payments will then be taxed as income in the normal way. Finally, it’s worth saying that this is an evolving area of the pensions market, with three insurers leading the way. The fixed-term annuities offered by Canada Life, Legal & General and LV all come with slightly different features, but it is worth
“This is still an evolving area of the pensions market”
getting quotes from all three. And if you’re unsure about the best options, take independent financial advice.