I received an interesting email from an adviser this week. He’d been asked to review a five-year fixed-term annuity that had recently matured. The client was unhappy that the maturity value could not purchase a lifetime annuity paying the same income as the fixed-term annuity.
The adviser asked for my thoughts and if I had a view on the prospects for annuity rates in the future. My first reaction was how many other clients would be disappointed for the same reasons and whether fixed-term plans are a good option.
Fixed-term annuities are a form of drawdown where a guaranteed income is paid for a set period of time and a guaranteed amount is paid back in to the pension plan at the end of the term.
On the positive side, fixed-term plans provide valuable guarantees and the flexibility to use the maturity value to either purchase an annuity or invest in a traditional drawdown plan. If necessary, another fixed-term plan can be arranged.
On the negative side, the maturity value, although guaranteed, may not be able to produce a high enough income to justify locking up the pension pot for a fixed term.
Let’s consider a simple example. Someone aged 65 can get about £5,000 per annum gross by purchasing a lifetime annuity with £100,000. If this money was invested in a fixed-term plan paying the same £5,000 per annum, the maturity value would be £82,400 in five years’ time.
At that point, the investor will be 70 years old and £82,400 would purchase a lifetime annuity of just under £5,000. This assumes that the underlying annuity rate remains the same and the annuitant is still in good health. On this basis, it is safe to say the fixed-term plan would be a good idea because it provides the same guaranteed income as an annuity with a second bite at the cherry.
If annuity rates were lower at the end of the five-year term, the maturity value would not be able to purchase the same £5,000 per annum. However, if annuity rates went up, or the person could benefit from an enhanced annuity, they would be able to purchase more than £5,000 per annum.
This leads me back to the central point; what are the chances of annuity rates rising over any five-year period?
As my annuity chart shows below, annuity rates have been in long-term decline since I began keeping records about 25 years ago. This doesn’t mean they will not rise in the future, and there are good reasons to think that rates will increase.
In my experience, very few people have benefited from deferring an annuity purchase because of the long-term fall in annuity rates. The only exception has been those who invested in equities and have seen the value of their pension fund rise more than annuity rates have fallen.
William Burrows is retirement director at Better Retirement