State Pension - deferring and top-ups

pshepherd

Hi

A female friend in her early 60s is currently deferring taking her SP to take advantage of the ~10% increase for each year deferred. She is currently receiving a smallish public sector pension, works part-time and is just in the 40% tax bracket for the last few years. She will probably continue working for another 12-18 months.

A recent Guardian article discussed the low taken up on Class 3A top-ups where £890 cash payment increases the state pension by £52/yr (indexed linked). The article and ensuing discussion gave the impression that, subject to certain conditions, life expectancy etc, it was a good deal.

I don't know her precise SP entitlement, however she has lived and worked in the UK for 40yrs so I assume it is circa £115 (£6k/yr), and she can afford to defer for a few years and could also afford to spend money on top up.

I wondered whether it would be better to spend say £6k on a top-up which earns £350/yr additional SP or use/spend the £6k to defer taking the SP by an extra year which would increase her SP by £620/yr.

Is my understanding of the rules (and maths) correct?

It did also occur that putting the £6k into a SIPP to reclaim the 40% tax may be better alternative.

Interested to know what people here suggest.

paul

bigfreddiel

The reason the top up option has had such a low take up is because it's not good value. Deferring is far more cost effective as you increase your sp by 1% every five weeks or 10.4% per year.

Cheers fj

jamesd

As bigfreddiel wrote, the class 3A top ups are a bad idea compared to state pension deferral and should not be considered by those who have not reached at least 81 years of age, which is about when class 3A starts potentially beat deferral. Or alternatively, use class 3A if you are already going to defer until at least age 81, doing both of them.

If you consider class 3A on it's own the deal is good, it's just that there's a better buy available instead, so take the better buy.

pafpcg

If she can afford it (and isn't that a possibility with an income subject to 40% tax), why not do both? Then she can boost the Top-Up pension as well as the basic State Pension by 10.4%pa. And reducing the 40% tax take by contributing to a SIPP should be considered too, certainly for next year.

But remember, that to gain anything from SP deferral, you must claim the State Pension at least 10 years before death. For those interested in a prediction of the optimum length of time to defer, there's a closely-argued analysis by John Dagpunar from 2015 which looks at life expectancy and annual survival probabilities here: http://onlinelibrary.wiley.com/doi/10.1111/j.1740-9713.2015.00814.x/full Most of the maths is beyond me but his graphs tell me that the optimum length of deferral for a 65-year-old man would be somewhere between 4 and 6 years and between 7 and 9 years for a 60-year-old woman (he also presents graphs for women reaching retirement age later as their SPA date increases). His analysis using the post-April 2016 deferral rate, leads him to conclude "Unless there is good reason to believe that an individual's life expectancy is appreciably larger than the UK national average, it is probably not worth deferring under the new pension rules."

State Pension Top-Up (aka Class3A) is best compared to buying an annuity. For a state-guaranteed (whatever you think that's worth and many commentors on the Guardian article have little confidence in that!) CPI-index-linked income for lifetime, you surrender your capital. For someone without family (or an overriding desire to preserve an inheritance) an index-linked annuity can make sense especially since it eliminates any need to keep juggling financial assets (and without family support that might be problematic as one gets increasingly frail). The Top-Up annuity offers a better return than current commercial annuity rates. But your friend has only until April 2017 when the offer is withdrawn (and in any case it's only available to those who reached SP retirement age before April 2016).

Declaration of interest: My partner and I have both made Class3A contributions and we've both deferred our State Pensions.

Silvertabby

It's only 10.4% for those who reached State pension age on or before 5 April 2016. For the 'newbies' it's 5.8%.

kidmugsy

Silvertabby wrote: »

It's only 10.4% for those who reached State pension age on or before 5 April 2016.

Yep, and it's only those people who can buy a top-up.

bigfreddiel

kidmugsy wrote: »

Yep, and it's only those people who can buy a top-up.

Exactly, you beat me to it, doesn't everyone know that? That's why I didn't mention it!

Cheers fj

jamesd

pafpcg wrote: »

a prediction of the optimum length of time to defer, there's a closely-argued analysis by John Dagpunar from 2015 which looks at life expectancy and annual survival probabilities here: http://onlinelibrary.wiley.com/doi/10.1111/j.1740-9713.2015.00814.x/full Most of the maths is beyond me but his graphs tell me that the optimum length of deferral for a 65-year-old man would be somewhere between 4 and 6 years and between 7 and 9 years for a 60-year-old woman (he also presents graphs for women reaching retirement age later as their SPA date increases). His analysis using the post-April 2016 deferral rate, leads him to conclude "Unless there is good reason to believe that an individual's life expectancy is appreciably larger than the UK national average, it is probably not worth deferring under the new pension rules."

Unfortunately, he's somewhat wrong. because:

1. he significantly disregarded the longevity insurance value in the number level you mentioned, but he did then cover it in a range of projections for those who do live longer than projected life expectancy, giving some idea of the longevity insurance aspect, which favours substantially longer deferral then the average case.
2. he disregarded the alternative investments that could be used instead and comparing them to deferral's returns is important because people do have to pick one or more of the available things to do. The cautious majority are likely to pick something substantially worse, like cash.
3. he mostly disregarded risk tolerance and capacity for loss, though he did give it a brief mention.

Longevity insurance has substantial value and both the 10.4% and 5.8% plus inflation levels beat the returns expected from commonly used investment alternatives. And risk tolerance will cause many to choose low return options that pay much less than deferral or Class 3A, producing a worse return than either of those or the best of the alternative investment options.

What he is right about is what happens if you consider solely break even calculations, absent any consideration of longevity insurance, alternatives, risk tolerance and capacity for loss.

I've previously used similar graphs to give estimates consistent with his for the break even only case, but now tend more usually to consider the other three/four issues and suggest longer than break even deferral times unless I know something about the health and other circumstances of the individual.

Thanks, though, I'd misplaced my older source of the similar curves and I'll link to that paper instead for my generic suggestions!

kidmugsy

jamesd wrote: »

What he is right about is what happens if you consider solely break even calculations, absent any consideration of longevity insurance, alternatives, risk tolerance and capacity for loss.

jamesd, do the same criticisms apply to John Kay's calculator?

http://www.johnkay.com/pension/

jamesd

Thanks, another one to consider.

Yes, it shares some of the limitations with regards to the longevity insurance aspect but you can do some approximating of that by increasing the life expectancy, just as you can in the Dagpunar case by looking at the graphs showing the break even for different life expectancies. I'd generally prefer the graphs because they make it clearer whether there's a sharp change or a very gradual one. And of course it has that nice feature of asking you to give the alternative investment expected return, so it's ahead in that as well as in providing the ONS life expectancy calculator, which seems at least not to be using life expectancy at birth, way better than many!

jamesd

Comparing them both for a man aged 65 with 0% return after inflation (assuming savings) I see that the after 6 April 2016, 0% growth, 21 years number at John Kay is 1 year and ten months to break even. If I pretend that it's a woman with a fake state pension age of 65 and 24 years to go it says 3 years and 4 months.

If I change the investment return to 4.5% to simulate long term UK stock market returns it says 0 years for women and men. I find that a little puzzling because 5.8% is higher than 4.5% but I'm not sure what it's doing with capital consumption or tax.

Now if I look at the Dagpunar case I see the writing saying that for a man the optimal deferral is 4.8 years under old rules and 0 under new and that this is ignoring both tax and spousal pension (the latter being inapplicable to the 5.% case anyway).

I don't know the reason for the differences but the John Kay numbers look a bit more likely to me.