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John Lawson: Fixed-term annuities have passed their sell-by date

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With another company pulling out of the market due to low demand, are advisers calling time on the fixed-term annuity?

Back in the old world before freedom and choice, fixed-term annuities had a place, albeit a niche one. Minimum investments of around £50,000 were required to establish a drawdown plan. Customers with modest savings looking to create a stable stream of guaranteed income over a short period of, say, three or five years were unable to achieve that using drawdown investments.

The fixed-term annuity was able to deliver what these customers wanted in a neat, simple package: draw a guaranteed income for a few years and then, at the end of that period, reconsider their options with a guaranteed lump sum.

In the last year or so the world has moved on but fixed-term annuities still do what they always did. Customers with modest savings now have the additional choice of drawdown, which has shed its minimum investment limits.

Having examined a large number of quotations for fixed-term annuities, the average commission-free annualised rates of return are less than 1.2 per cent for five-year fixed annuities.

However, these returns now have to compete against drawdown Sipps, which can invest in fixed-term deposits that provide guaranteed (up to FSCS limits) income (interest) of between 2 per cent for one year and 2.9 per cent for a five-year term deposit.

Even allowing for a platform (Sipp admin) charge of, say, 35 basis points the returns available on fixed-term deposits are significantly better than the returns available on fixed-term annuities.

Using fixed-term deposits, it is possible to create an income stream and capital return that replicates the structure of a fixed-term annuity product. For example, for the first year’s income withdrawals, use instant access or current accounts; for income starting in 12 months’ time, use a one-year fixed term deposit and flip the proceeds into instant access in one year’s time and so on. For the guaranteed maturity value, use a three- or five-year fixed term deposit.

If the total investment is below £100,000 then the full sum should qualify for FSCS protection assuming the fixed-term deposits are placed with a couple of different banking groups.

Packaging up a guaranteed income stream in this way is relatively straightforward even if it does involve a little bit of extra administration up front.

Looking at one of the market quotes (around the average return on revenue) for a fixed-term annuity will help bring this to life.

The quotation is for a joint-life where the first life is aged 67 and the second aged 71 over a five-year fixed-term. The amount invested is £247,500, the annual income is £14,000 and the guaranteed maturity value is £191,390.

Assuming market-leading fixed-term deposit interest rates available to Sipps of 0 per cent for the first year’s income, 2 per cent for the second year’s income, 2.3 per cent for the third year’s income, 2.55 per cent for the fourth year’s income and, 2.65 per cent for the fifth year’s income, we need to invest £66,694 today to provide a fixed income of £14,000 a year over five years.

That leaves £180,806 left to invest to provide the guaranteed maturity value. On that deposit, we can earn an annual interest rate of 2.9 per cent using a five-year fixed-term deposit, which would produce a capital sum of £208,588 in five years’ time.

That capital sum is £17,198 better than the £191,390 maturity value available from the fixed-term annuity, with the annual income from both the Sipp and fixed-term annuity identical at £14,000 a year.

Another alternative would allow a higher income from the Sipp over five years and an identical maturity value to the fixed-term annuity.

At the level of this particular example, you might have to place deposits with a number of different banking groups to gain full FSCS protection but that should not present any great difficulty and the rates from the second and third placed deposit takers are not significantly below the market leader.

This simple maths brings home the predicament now facing fixed-term annuities and it is hard to draw any conclusion other than they have now passed their sell-by date.

John Lawson is head of pensions policy at Aviva

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Comments

There are 5 comments at the moment, we would love to hear your opinion too.

  1. William Burrows 29th June 2015 at 10:41 am

    I am just writing about Fixed Term myself – one of my conclusions is that there is a strong case for fixed term for those clients where it is not practical to invest in separate cash deposits but where certainty and flexibility is needed. Therefore they will benefit from a packaged product

    I think the debate about fixed term is better served by looking at which groups clients will benefit from packaged products like fixed term especially in light of the so-called advice gap. Especially where fixed term is part of a cocktail solution

  2. I note Aviva pulled out of this market – just as Canada Life and Legal and General entered. I have to say simplicity counts for a lot too – and the sipp/deposit structure doesn’t have that.

  3. If you consider the principle of the fixed-term annuity ahead of ‘how’ it is delivered, whether through a packaged product or Platform based SIPP, the attractiveness remains. The FTA is a good way of offering the flexibility of drawdown (e.g. not fixing choices for life) but without some of the more volatile aspects of equity based drawdown. With a known and certain income, zero volatility and a guaranteed maturity value they have proved attractive and useful for those, for example, looking for a bridge between early retirement and when their state/DB scheme starts.

    Of course FTA’s can lull the unwary into a false sense of security. With all this talk of certainty, low volatility and guarantee’s it is easy to overlook the fact that if you withdraw too much income (even easier now) then your guaranteed value may not be able to replace that income at maturity.

    As John points out the returns are poor but the packaging makes it simple to arrange, even though you could DIY an FTA using a normal drawdown SIPP wrapper. I suspect that FTA’s may evolve into (dare I say it) structured product ‘like’ fund options that are built and offered to be placed inside an existing SIPP wrapper just another of the many fund choices available already. The arrangement sits alongside any other investment strategy (that maybe used for growth) and the maturity value reamins available at the end of the term ready for the next decision. Job done!

  4. Researching and arranging five different SIPP deposits – ten if two banking licences are required to secure FSCS protection – and then ensuring that on maturity they pay out as required (some banks try to get away with automatically rolling over) is not what I would classify as “a little bit of extra administration”. If you are charging an appropriate fee for all this form-filling and chasing then the effective return might end up a little bit closer to that of the fixed term annuity.

    However, if the overall conclusion is that fixed term annuities are rubbish as an investment then none of us would disagree with that. I have never been quite sure what the point is – they are very poor as an investment, and offer very little in the way of certainty because of the possibility that annuity rates may be considerably worse when you receive the maturity value.

    Consequently they were a classic “falling between two stools” product even before pension freedom. If you want certainty of income you buy a lifetime annuity and if you are happy without certainty you use drawdown. If you know that you will require X income over the next 5 years but don’t know about beyond that, you would most likely be far better off leaving 5*X in cash, drawing from that and investing the remainder for capital growth.

  5. There is definately a place for ‘Fixed Term Flexi Drawdown’ type product in the market. A packaged product proposition, as highlighted by John, wrapped around a simplified SIPP with a series of instant access/Fixed Term deposits to produced a required income stream and a maturity amount at the end of a period has some appeal for risk averse customers. Fully agree with Sascha that researching and arranging different SIPP deposits with different Banks and then wrapping it around a simplified SIPP is not as easy matter.

    Interestingly, just been approached by a company who has developed a packaged solution as described in the article. They are called Assured Retirement Ltd. Here is their website link
    http://www.assuredretirement.co.uk. Worth looking at it as part of your advice solution for your maturing clients pension assets.

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