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


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