Stick or twist?
The vast majority of people simply take the state pension when offered and spend the money or leave it lying in a bank or building society account.
In this section, we consider various other options, as follows:
Re-cycling “unneeded” state pension payments into a pension plan.
Deferring state pension in favour of a higher pension at a later date
Deferring state pension and collecting a lump sum later
Deferring state pension for a higher pension later
The topic of deferring the taking of state pension in favour of obtaining a higher pension at a later date has attracted considerable new coverage recently, on account of the government changing the terms of deferment so that they are less generous.
Under the old rules, the state pension increased by 1% per annum simple (not compound) for every 5 weeks of deferral. That was equivalent to 10.4% per annum simple.
Under the new rules, the state pension now increases by 1% per annum simple for every 9 weeks of deferral. This is equivalent to 5.8% per annum simple.
The table below compares the state pension if taken from the outset, with the starting level of state pension if deferred for a particular number of years, and computes the difference in state pension. We have assumed that the base state pension amount will grow by 2.5% per annum compound.
State pension deferment (assuming RPI of 2.5%) Age State pension commenced at age 65 Starting state pension if deferred 65 7,717 - 66 7,910 8,367 67 8,107 9,044 68 8,310 9,751 69 8,518 10,486 70 8,731 11,253 71 8,949 12,051 72 9,173 12,833 73 9,402 13,748 74 9,637 14,649 75 9,878 15,586
By way of example, if Bob starts drawing his state pension at 65, it will be £7,717 in year 1, rising (assuming 2.5% inflation) to £8,107 when he is age 68, and £8,731 by the time he gets to 70.
If he decides not to take his state pension at 65 but waits until age 67 to start drawing it, he will (taking account of the deferral factor of 5.8% per annum simple and assuming inflation of 2.5% per
annum compound) receive a pension of £9,044 to begin with. Likewise, if he holds off from taking the state pension until he is 71, the amount payable will kick in a £12,051 to start with.
The question is whether and to what extent Bob would really gain from deferment. For example, how much is he really benefiting from, say, postponing taking his state pension until he is 70 in return for a pension income that is £2,522 higher at that date than payable to another 70 year old who has been taking state pension since he was 65?
The act of deferring a state pension is effectively the same as buying an annuity. The calculations are a little tricky given that we are mixing up simple interest and compound interest, but our favoured money-weighted (IRR) approach will help us.
The answer, as may be seen from the table below, is that the longer you live, the greater the benefit from deferment. We can also see that, deferring for longer is worse.
IRR of deferring state pension after age 65 (assuming 2.5% RPI)
Period of deferment
Age of death (completed years) of pensioner
70 75 77 80 83 85 90
1 yr -39% -9% -5% -0% 2% 4% 5%
2 yrs -47% -11% -6% -1% 2% 3% 5%
5 yrs - -20% -12% -5% -1% 1% 4%
7 yrs - -31% -17% -7% -3% -0% 3%
If we focus on outcomes at age 83 (Bob’s life expectancy as a 65 year old man), deferring for one or two years might produce a slightly positive return if he lives that long, but an IRR of 2% really does not appear to be good compensation given the longevity risk he is taking by deferring, which could go against him considerably if died at a relative young age (as per the -39% IRR if he died having completed 70 years).
On the basis of the data above, deferring taking the state pension now looks like a bad bet, with the financial impact of longevity risks very much to the downside as far as the pensioner is concerned.
Recycling state pension
So these days, deferring the taking of state pension does not look like a good idea. But, for some clients who do not need this money straight away, recycling it into a personal pension (subject to usual constraints of contribution limits, as well as rules on accumulating vested pensions) could be worthwhile if they have the right income tax profile.
The state pension is paid gross but subject to income tax. For clients whose total income (including the state pension) is within their personal allowance, it would be possible to benefit from the “grossing up” of their gross basic state pension by recycling it into a personal pension.
Impact of state pension recycling assuming 20% tax relief & fund growth of 0% p.a.
Item Number of years state pension is re-cycled starting from age 65
1 2 3 4 5 6 7 8 9 10
Fund value (£) 9,646 19,533 29,668 40,055 50,703 61,616 72,803 84,248 96,022 108,068
IRR (%) 49.1 23.2 15.2 11.3 9.0 7.5 6.4 5.9 5.0 4.5
In the table immediately above, we plot the impact of recycling the state pension (which we assume will rise at the rate of 2.5% per annum so that contributions made over each year will be the same as in the first column in the table on the previous page), including the impact of “grossed-up” tax relief at 20%. To isolate and emphasise the impact of the tax relief, we assume fund performance of 0% per annum, and show the progression in IRR at each point in time.
It can be seen that the IRR diminishes the longer this strategy is pursued. This is because of the proportionate impact of tax relief at any time. That having been said, the money weighted returns are exceptional over the early years, even assuming nil investment return.
Of course, the client is likely to want to access the recycled pension pot at some point, which will involve consideration as to availability of tax-free cash, the tax rate applying on any funds withdrawn, whether to decumulate within the pension or, in some cases, the possibility of trivial commutation. In summary, for clients with the right tax profile who do not need their state pension immediately, recycling it into a personal pension could be a much better option than deferment. Even adopting an investment strategy with low but secure returns (money market funds or short dated gilts), and allowing for tax, there is the prospect to generate reasonably attractive IRRs over the near term.
Deferring state pension for a lump sum
Provided that they put off claiming state pension for at least one year, clients deferring taking their state pension have the option of receiving a lump sum instead of extra pension.
The lump sum is based on the amount of state pension that would have been paid, plus interest on that amount at a rate that “will always be at least 2% above the Bank of England base rate”.
Under this lump sum option, state pension will be paid at the normal rate when it is claimed.
Any lump sums may be subject to income tax, but will not be taken into account when assessing entitlement under new claims for pension credit or housing benefit.
With regard to taxation, lump sums are not added to the rest of one’s income to work out the total income for tax. Instead, the rate of tax due on the lump sum will be the highest main rate of tax paid on other income (includes any weekly state pension once it starts to be claimed). Special rates of tax that apply to savings and dividends are not counted.
The tax rules for state pension lump sum payments are different from the tax rules that apply to any lump sum payment that from an employer’s pension scheme or a private pension. This means that, for the state pension lump sum:
if no tax is paid because other income, including any state pension, is less than the personal allowance, no tax will be payable on the lump sum;
if tax is paid on any part of other income, including state pension, at 20%, tax will be paid on the lump sum at 20%;
if tax is paid on any part of other income, including state pension, at 40%, tax will be paid on the lump sum at 40%;
if tax is paid on any part of other income, including state pension, at 45%, tax will be paid on the lump sum at 45%.
Accordingly, receipt of a state pension deferral lump sum payment will not put a pensioner into a higher rate of tax than the rate that already applies to his or her other income.
Also, it will not lower the increase personal allowance applicable to people born before 6 April 1948.
September 2014 Cazalet Consulting Standbrook House 2-5 Old Bond Street London
W1S 4PD 020 7499 5818
www.cazalet-consulting.com
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