Should I defer my pension?

As you approach the age when you can get your state pension should you claim it or not? Of course if you are retiring and need the money then the answer is ‘yes’. But if – like so many people nowadays – you plan to carry on working, is it better to claim your pension or put it off? Deferring your pension can be attractive because you will get more money when you eventually do claim it. But then you face another difficult choice about how that extra is paid.

First, you can choose to have a higher pension. The whole pension – including any SERPS – will be increased by 1% for each five weeks you defer. So a year’s deferral increases what you get by 10.4% and if you defer by five years your pension will be increased by just over half which means a £100 a week pension becomes £152. If you can wait ten years your pension will be more than doubled – £100 a week due at 65 would be £204 if you did not claim it until you were 75. And that is without taking account of the annual inflation rise.

Although the basic pension will rise in future years in line with earnings or prices whichever is the higher, the extra pension from deferring your claim will rise only by prices as measured by the Consumer Prices Index. In 2010 the basic pension rose by 2.5%. But any extra pension did not rise at all, despite statements in leaflets that it would rise with inflation in the same way as the basic pension. That leaflet has now been changed.

Alternatively, if you have left your pension unclaimed for at least a year, you can choose to take the pension you have given up as a lump-sum. So every penny you would have been paid is paid to you in a lump-sum when you claim your pension. In addition the government will add interest to this payment as if your pension had been going into a savings account each week earning 2% above the Bank Rate. That is currently 0.5% so your pension will earn interest equivalent to 2.5% a year. If Bank Rate rises then the amount that is added will also rise from that time.

Lump-sum or enhanced pension?
You do not have to choose between these two options until you finally decide to claim your pension. But which is best? At first sight the lump-sum seems attractive. If you defer a £100 a week pension for two years you would get a lump-sum of £10,660. But almost all of that – £10,400 – is the pension you have given up. Only £260 is the interest of 2.5%. Alternatively if you choose the enhanced pension it would be raised by nearly 21%. That would give you an extra £20.80 a week or £1082 a year. So after ten years you would have had more in enhanced pension than the lump-sum payment. The break even point is more complicated than that – it depends on what the Bank Rate is and money now is always worth more than money paid over the next ten or twenty years. But the longer you live the more attractive the enhanced pension becomes. If you have health problems or smoke – or if you need the money now – then it is probably better to take the lump-sum. If you expect to live a long time then the enhanced pension will be better value.

The lump-sum is taxable, but in a strange way. It is not added to your income and taxed. Instead, tax is deducted at the highest rate you pay on all your other income in the tax year you claim the lump-sum. So if you are a non-taxpayer then no tax is due on it. You can defer receiving the lump-sum by one tax year after claiming your pension if that will reduce the tax that is due.

The lump-sum does not affect entitlement to the higher tax allowance for people aged 65 or more nor does it count as capital if you claim a means-tested benefit such as pension credit or council tax benefit. For some people taking the lump-sum rather than the increased pension might mean their entitlement to means-tested benefits is increased.

Bird in the hand
Some people prefer to take their pension as soon as they can, even if they do not need it, and put it into a savings account. You can claim your state pension even though you are still working and no matter how much you earn. But the pension is taxable so if you claim it and carry on working you will probably have to pay tax on the weekly pension you receive. That is done by taking more tax off the rest of your income. So the amount of pension left to put into a savings account will only be 80% of the full amount (or 60% if you are a higher rate taxpayer.) So if your pension is £100 a week you will only have £80 after tax to put into your savings account. And once it is there the interest it earns will also be taxed. This double whammy of tax makes this option rather unattractive.

On the other hand, if you do not claim your pension and it builds up into a lump-sum, the interest it earns is worked out on the gross amount of the pension before tax. In addition no tax is charged on the interest when it is added. As a result the current 2.5% which the Government adds is the equivalent of earning interest at 3.91% for a basic rate taxpayer whose pension and interest are both taxed before being saved. It is impossible to earn that much in an instant access account. You can get more than 4% in an account which ties your money up for several years. But by the time you can take it out Bank Rate may be a lot higher and the Government deal a lot better. So it is almost certain that if you want to save your pension up for when you do retire it is better to defer your pension and let it build up with the Government than take it out and do the job yourself.

Inheritance
However, there is one big advantage of taking your pension and saving it up yourself – inheritance. If you draw your pension and save it up but die before you get to use it, all that money will form part of your estate to be inherited by your heirs. The same is true if you have already claimed your pension lump-sum and then die. However, if you die before claiming your pension the rules about what happens to your lump-sum are much more complex.

If you have a spouse or civil partner they can normally inherit your lump-sum payment, though they will have to wait until they reach pension age. Alternatively they may be able to inherit some of your higher pension. But if you have no spouse or civil partner and die before you claim your pension then your heirs can only get three months of your pension – all the rest of your unclaimed pension is lost forever. That is why when the lump-sum option was introduced the figures showed that it would actually save the treasury money overall. If you do fall ill before you claim your pension and you fear you may die then it is sensible to get the claim in before that happens.

More information
direct.gov.uk and put ‘defer state pension’ into the search box. A full guide to the rules, SPD1 (February 2010), can be downloaded.

e-mail Paul Lewis on paul@paullewis.co.uk