The little-known trick to lock in a guaranteed 9% return on your pension income – here’s exactly what you need to do…

Many over-55s are missing out because they are unaware of a valuable trick that could guarantee income in retirement – without locking away their pension savings for life.

Reliable income in retirement regularly features at the top of a pension saver’s wish list. Traditionally, this has meant using your pension pot to buy an annuity, a financial product that can provide a set income for life.

But this security usually comes with a lack of flexibility. Once you have bought an annuity, you are locked in for life and when you die the payments stop – unless you have bought death benefits for a spouse – and the pension fund used to buy the annuity is gone.

But a ‘fixed-term’ annuity instead of the common ‘lifetime’ option could boost your retirement income, guarantee a future payout, keep your options open and avoid an unspent pot being lost if you die early.

A fixed-term annuity pays out for a set period, usually five to ten years. You then get a lump sum at the end. And, if you die before the fixed term ends, the remaining funds are usually paid to a beneficiary.

For example, a saver using a £100,000 pension pot to buy a five-year fixed term annuity could get a rate of 9 per cent, plus £77,690 back at the end, compared to 7.75 per cent on a lifetime annuity.

Advisers say these fixed-term annuities not only offer greater flexibility but also higher payouts, and more pension savers should consider them as an alternative to keeping their pot invested.

The annuity comeback

Workers who retire with defined-benefit pension schemes, also referred to as final-salary schemes, have a promise from their last employer that says it will pay them an income for life based on length of service.

But outside of the public sector, these pension schemes have died out, as employers have cut costs and replaced them with cheaper defined-contribution schemes. Here workers and employers both contribute, and an investment pot is built up that the saver must turn into retirement income.

For many years, the way most people did this was by buying an annuity. But annuities began to get a poor reputation after the financial crisis, when the knock-on effect of interest rates being slashed sent their payouts tumbling for new retirees.

Savers who failed to shop around received poor deals, while for those who died early anything remaining in their pension was lost.

When former chancellor George Osborne announced his so-called pension freedom rules, which swept away the need for most people to buy an annuity with their pension pot, many savers gladly opted to keep their pensions invested and draw a flexible income instead as they needed it.

But with interest rates having risen again in recent years, annuities have staged something of a comeback and financial advisers say that for those who want reliable retirement income they are worth considering again.

A 65-year-old with £100,000 could buy an income of £5,500 when pension freedom was introduced in April 2015, but could get £7,800 on the same terms now.

Despite higher annuity rates on offer now, the idea of locking in for life still puts many savers off. Those who don’t want to risk investing their pension or commit to buying an annuity for life have a halfway house option, however.

Higher interest rates have made fixed-term annuities better value, just as they have boosted rates on traditional annuities that pay a guaranteed income for the rest of your life.

They are also flexible not only because they are temporary, but because you can adjust the product conditions according to whether you want an income only, an income plus a payment at maturity, or simply a lump sum at the end of the agreed term.

Fixed-term annuities: A bigger payout and flexibility

The problem with leaving your pension in the stock market and using so-called drawdown for ad hoc withdrawals is working out how much income to take without depleting your pot. There is also the risk of your fund collapsing if stock markets tumble.

Fixed-term annuities offer an income payout that rivals the return on the stock market. 

Meanwhile, the monthly income and maturity payouts are guaranteed, so you have certainty over what you will get. The downside is you don’t get the same potential for growth from stock markets.

With a fixed-term annuity, you can take a 25 per cent tax-free lump sum at the outset, just like with any other pension arrangement.

You can also decide if you want: a higher income only during the fixed term, with nothing left at the end; a lower income during the fixed term, plus a guaranteed maturity payout at the end; or no income, just a guaranteed return at maturity, from the compound interest you accrued.

If you die before the end of the term, your estate or nominated beneficiary can receive the remaining income, the maturity value, or both depending on the options selected.

Justin Wysocki, chief revenue officer at pensions advice specialist Pense, says this kind of annuity offers certainty during the term but flexibility later, because at maturity you can move into ad hoc drawdown, buy a new annuity, or take the pension as cash. 

He adds: ‘It offers a middle ground between full drawdown and a lifetime annuity. Fixed-term annuities are ideal for clients who don’t want investment risk, want to access their tax-free lump sum, but aren’t ready to draw income, or want control, certainty, and built-in flexibility for changing circumstances.’

Providers include Canada Life, Legal & General, LV Insurance and Standard Life.

What income will a fixed annuity pay?

William Burrows, boss of pension information site the Annuity Project and a financial adviser at Eadon & Co, crunched the numbers for a lifetime versus fixed-term annuity.

For a 60-year-old, a £100,000 pension pot can purchase an annuity with £7,600 of pre-tax annual income guaranteed for life, he says. 

This is a single life policy, meaning no death benefits for a spouse, and ‘level’ payments so no increase for inflation each year.

By comparison, a five-year fixed-term annuity could pay the same £7,600 income plus a guaranteed maturity amount of £85,000 at the end. This would mean you will have received £123,000 in total over the five years, having started with £100,000.

Burrows says another option is to set the maturity amount at the same level as the fund paid in. In this instance, the five-year fixed term annuity would pay £5,000 annually, with the full £100,000 back at the end.

That means you have received £125,000 over the five years.

If no income is paid the guaranteed amount after five years will be £129,270 – representing a return of 5.25 per cent per annum compound.

Savers would be right to ask how providers are able to offer these rates. The answer lies in the way they invest funds and the fact there isn’t a huge amount of demand from savers for fixed-term annuities, so rates need to be competitive.

Burrows explains: ‘Fixed-term providers invest the purchase money into assets such as long dated gilts such as UK government debt, corporate bonds, sovereign debt and commercial property. 

‘The yields on these assets are used to calculate the underlying interest rates and returns.’

Nick Flynn, retirement income director at Canada Life, says: ‘Many customers are relatively unaware of fixed-term annuities. 

‘We typically see customers purchasing five or ten-year fixed-term annuities but longer time frames are available too.’

What to check before buying

When you explore buying a fixed-rate annuity, Burrows says you should find out the following: the amount of income you would get; the term; the guaranteed maturity amount and what happens on death.

He warns: ‘At the end, the term interest rates may be lower and so the lifetime annuity rates available then will also be lower. 

Personal circumstances may change and you will be locked in until the end of the term.

‘On death you may lose out unless the right death benefit options were chosen. Just as with lifetime annuities, there are a number of options which pay out money if the plan holder dies before the end of the term. However, these options will reduce the amount of income payable.’

Check all the details very carefully as to what happens in different circumstances.

If you opt for a joint life policy, income can continue to a spouse or partner, normally at half, two thirds or the full amount of what was paid to the original policyholder, says Burrows.

With a lifetime annuity, for £100,000 a healthy 65-year-old can currently lock in income of £7,800 a year, according to best buy data from Hargreaves Lansdown.