Should you defer commencement of your State Pension and, if so for how long?
If you are lucky enough to have reached State Retirement Age before 6.4.2016, you can profit quite handsomely from waiting a year or two before requesting commencement of State Pension. On the face of it, you can make a tidy profit in the form of a 10.4% increase in your pension just by deferring it for one year. Or, to be more precise your pension increases by 1% for every 5 weeks deferred.
If you reach State Retirement Age on or after 6.4.2016, the equivalent rates are 5.8% after one year or 1% for every 9 weeks deferred.
Deciding to defer for one year is a pretty easy thing to do but, assuming you don’t need to have immediate access to the pension, for how long should you defer?
The drawback to deferring lies in the fact that, once in payment, a state pension ceases to be payable on death. There must therefore be a time when the risks of continuing to defer outweigh the advantage of receiving a significantly higher pension income through deferment.
Also, although you are entitled to regular inflationary increases in the base pension value in addition to the 10.4%/5.8% increase, the inflation rate used to increase the base pension value is the CPI whereas increases to pensions in payment currently enjoy the so called triple lock increase of the highest of inflation, earnings and 2.5% each year. And, the increase of 10.4%/5.8% is not allowed to compound in the best way possible – instead only the CPI increases are compounded and the deferment bonus is applied each year as a fixed amount against the CPI increased amount.
The decision is a little more complicated than it first seems but can we get closer to the truth than mere guesswork? In essence, yes.
The correct answer is a function of past and future inflation, interest and growth rates plus possible future changes in government policy. So, the best we can do is arrive at an approximate answer but the aim of an analysis would be to do the best possible at arriving at that approximation.
A couple of months ago, I was requested to give this some serious thought and arrive at the best advice conclusion possible. The first thing I did was to look around the Internet to see whether someone else has already arrived at a sensible conclusion. Sadly, none of the reputable sources I looked at tackled the problem convincingly. Also, none of them actually made an attempt to calculate the advantage in terms of an annualised interest rate, taking all factors into account.
After some thought, I arrived at a shortlist of two methods and settled upon one which I think does the best job of revealing something a little closer to the truth.
The thought construct I chose is to imagine two people with the same date of birth. Person A takes the State Pension immediately while person B defers. We can then assume both die on the same day and ask, “which person did better than the other”? I broke the calculation down into three stages.
In stage one, I assumed person A’s state pension money is paid into a tax-sheltered vehicle and left to accumulate – thereby eliminating any skew in the comparison due to timing differences between persons A and B.
In stage two, I calculated the difference in the value of state pensions paid to person A and B then allow the person A to make withdrawals from his accumulated fund to match exactly the difference between his lower state pension and person B’s higher pension.
In stage three, I calculated when person A’s accumulated fund runs dry.
Then, if that date is before the anticipated death of person A, person A suffers financially compared to person B and vice versa.
All of this was modelled in a spreadsheet for ease of calculation and layout control.
Of course, there are a number of key drivers and assumptions necessary.
- The actual date of death is the principal driver. Obviously, this date is unknowable in advance but I invite you to accept the average date of death for a person of your age assuming no life limiting health issues have yet arisen.
- I assumed the inflation rate applicable to state pensions in payment will be constant at 2.5% per annum and a lower CPI rate of 1.5% per annum. The final results did not move by much if I used more aggressive numbers.
- Income taxation is another significant driver, so I made sure this was taken into account.
The result was expressed as a fixed rate of interest which person A must achieve over the rest of his life on the value of the pension, he saves to one side instead of deferring as done by person B.
As you might expect, the “interest rate” you achieve by deferring reduces over time. The longer you defer, the weaker the effective financial return becomes. But, even small returns are acceptable in may instances because the nearest equivalent rate if that of a fixed interest deposit account.