Fixed Term Plans
Historically, the only way to convert a pension fund into income was by purchasing a lifetime annuity or investing in pension drawdown. One is totally secure but inflexible, the other completely flexible but has a number of risks.
Then in 2007 the first fixed term annuity or fixed term income plan in 2007 was launched.
These are plans which pay a guaranteed income for a specific period of time and at the end of the term there is a guaranteed amount paid pack into the plan.
Fixed term income plans are a type of drawdown plan which means that income payments are paid directly from the pension fund and the amount of the fund left over after making these payments is paid back to your pension plan
Just as with all other options, you can normally take a 25% tax free cash sum from your pension pot before the fixed term plan begins.
There is an importance difference between a fixed term and drawdown plan. With a drawdown plan you decide how much income is paid but neither the income or remaining fund value can be guaranteed. Whereas with a fixed income plan both the amount of income and the remaining fund value are guaranteed.
Combining guaranteed income and pension flexibility
Fixed term income plans play an important role in retirement income planning because they are one of the few solutions which combine guaranteed income and pension flexibility.
They solved the problem of how to get a guaranteed income without losing control by purchasing a lifetime annuity whilst at the same time retaining flexibility and control without taking the risks associated with pension drawdown.
The key to understanding fixed term income plans is to recognise the two different parts;
- The income that is paid for a set period of time
- and the maturity amount which is a lump sum paid back into the pension pot at the end of the term.
You can choose the amount of income taken and over what period but just like with drawdown, the more income taken the less money left in the pension pot and just like an annuity, the income is guaranteed albeit not for life.
The unique and most appealing feature is the maturity value which is paid at the end of the term because this can be used to pay a lump sum (taxed at the recipient’s marginal rate of tax), purchase an annuity or remain invested under drawdown rules.
Fixed term plans may be simple to understand but it is important to understand the disadvantages, as well as the advantages and these, are set out in the table below.
|Guaranteed income for a fixed term
||There is no long-term income security
|Flexibility at the end of the term
||Financial conditions, e.g. annuity rates may be worse in the future
|On death, there may be a lump sum that can be paid to their partner or family
||Some people prefer continued lifetime income for their partner rather than a lump sum
|Allows people to secure some guaranteed income without locking into a lifetime annuity
||The guaranteed income is only for a set period of time so there is no lifetime income guarantee
|Enables retirees to have flexibility over how they eventually spend their pension pot
||Used unwisely, flexibility can result in poor income outcomes
In my guide to fixed term income plans I give four practical examples of how fixed term plans can be used in retirement planning.
The first example is a person who wants a guaranteed income but is concerned about low annuity rates and that their health may deteriorate in the future. They invested in a five-year fixed term, took the same income as would have been paid from a lifetime annuity in the knowledge that they might benefit from higher annuity rates or an enhanced annuity at the end of term. Of course, a prudent adviser would point out that annuity rates could be even lower at the end of the term.
The second example reflected a common situation; someone wanting a relatively high level of secure income to bridge the gap between retirement and the start of the state pension.
The third example looked at the increasingly important issue of de-risking drawdown in later life. In this example, the retiree converted part of his large pension into a fixed term plan to provide secure income and the reduce risk.
The fourth example was a less frequent issue but never the less very important. A retiree with other sources of income and on the border between basic and higher rate tax who wanted to cash out a pension pot over several years and avoid paying higher rate tax.
In conclusion, pension freedoms have ended the days of selling lifetime annuities to people who neither understand them or wanted them because now financial advisers and their clients must focus on which solutions achieve the best outcomes and meet retirement objectives.
The more tools advisers have in their toolbox the better. Fixed term income plans should be in every adviser’s toolbox because even if they are not used all the time there will be times when a fixed term plan will provide the best outcome.