Earn up to 12% on your pension pot

Investors over fifty can earn guaranteed, secure and ultra-high rates of return on their spare cash, thanks to this pension loophole.

Since October, the Bank of England has cut its base rate by four percentage points, from 5% to 1%. While this makes life easier for British borrowers with large, variable-rate mortgages, it makes survival equally hard for savers!

The savings-rate slump

Sadly, the rate paid by a typical easy-access savings account has collapsed by four-fifths (80%) over the past twelve months. After deducting basic-rate tax of 20%, the average savings account now pays around 0.8% a year, which comes to a measly £8 for every £1,000 deposited. For higher-rate taxpayers, this income drops to £6 per £1,000 on deposit.

Having lost out in the rate war, millions of savers are desperately seeking ways to improve the income generated by their spare cash. Many are turning to corporate bonds -- company IOUs which can offer a yearly income in excess of 6%. Others are looking to the stock market, buying high-yielding shares -- those which pay a high income to their owners.

However, unlike cash savings, any money invested in bonds or shares is at risk, so you may get back less than you pay in. However, there is one way to earn a high, guaranteed return without putting your spare cash at risk. Here's how it's done:

The 'instant pension' loophole

Anyone up to the age of 75 (including children) can contribute to a pension and earn basic-rate tax relief of 20% or higher-rate tax relief of 40% on these contributions (depending on your income tax band). The upper limit for tax relief is 100% of your salary, up to a maximum contribution of £235,000 in the 2008/09 tax year.

What if your income is so low you don't have to pay tax? Then your maximum pension contribution is capped at £3,600 per tax year. But you only actually need to contribute £2,880 to achieve a pension pot this size. This is because you still benefit from 20% basic-rate tax relief - so you effectively get a £720 contribution from Her Majesty's Treasury.

Furthermore, if you are aged between 50 and 75, then you can immediately withdraw a quarter (25%) of this pot as tax-free cash. In other words, you can get back £900 of your £3,600 straight away. So, after deducting the £720 tax relief and tax-free cash of £900, a pension contribution of £1,980 nets you a pension pot of £2,700.

Your next trick is to use this £2,700 pot to buy a pension annuity -- a guaranteed income paid by an insurance company until you die. You can choose to have this annuity income paid yearly in advance, which means that you can grab your first year's payment straight away. Note that annuity rates increase with age and women are paid lower rates than men, simply because females live longer.

So, by making full use of pension tax relief, tax-free cash and yearly annuities, you can earn super-high -- yet secure -- returns on your spare cash. Here's a table of possible returns on offer (based on a net contribution of £1,980 minus the upfront yearly income shown in the table):

Source: Hargreaves Lansdown. These annuity quotes are from Standard Life; annuity rates from other insurers may differ.

As you can see, a 74-year-old man can get a (taxable) income of £211.21 a year by buying an annuity with £2,700. As his first yearly income will be paid right away, his net contribution of £1,980 is reduced to £1,768.79. Thus, his annual return is £211.21/£1768.79, or 11.94% a year.

What's the catch?

The biggest catch with annuities is that you surrender your capital. In other words, you hand over your entire pension pot on day one -- and your income dies with you. Also, dying young means that you could lose the 'annuity gamble', as your total income could be less than your original investment. In addition, some of your annuity income will form part of your overall taxable income, so extra tax could be due on the yearly payments you receive.

Finally, a retired couple with £14,400 to spare could invest four lots of £3,600 into pensions over the next three months, using up their 2008/09 and 2009/10 allowances. By doing so, they could receive a decent yearly income for the remainder of their lives. On the other hand, much of this £14,400 would be gone forever, so it pays to think carefully before piling money into pensions...

Many thanks to Nigel Callaghan at Hargreaves Lansdown for his help with this article.

More: Learn more about pensions and retirement | Five things to do before you retire| Five reasons why ISAs are better than pensions