The Pros and Cons of a Deferred Pension
Deferring a pension is one way to end up with more when you eventually do retire by delaying the receipt of payments for a few months or years. The deferred pension does have its pros and cons, so these need to be considered carefully in light of a saver's overall investment and retirement goals. If you know nothing about deferring a pension, the first step is to educate yourself.
The first thing you need to know is that the term 'deferred pension' can apply to both private and state pensions. For the purposes of this discussion, we will focus on the deferred state pension. In brief, a private pension that is deferred is simply an occupational or personal pension you are no longer contributing to but which is continuing to grow through investment.
The deferred state pension is similar to the deferred private pension in some ways and different in others. Let us begin by talking about how the state pension system works.
State Pension Contributions and Payments
You will be eligible to receive state pension payments in retirement by virtue of the fact that you have contributed to the scheme through National Insurance. How much your eventual payments are will be directly tied to your contribution record. You will be eligible to begin collecting payments when you reach state pension age. That age is gradually set to go up to 67 for both men and women over the next several years.
A few important things you need to know about the state pension:
- Receiving Payments – The government will assume you want to begin receiving state pension payments when you reach retirement age. However, receiving payments is not required. You can inform the government that you wish to defer your payments for the time being. This is what classifies as a deferred pension.
- Second State Pension – The second state pension is being phased out from April 2016. Any contributions you made to the second state pension system will be included in your pension payments based on a formula applied by the government.
- Retirement Income – The state pension has never been intended as a primary source of retirement income. Do not depend on it as such. Even by deferring your state pension payments for a few years, you will still not be getting enough to provide the lion's share of your retirement money.
- Additional Contributions – If you are among those workers caught in the no man's land resulting from opting out of the second state pension, you can make additional contributions between now and 2017 in order to cover gaps in your national insurance record. Your financial advisor should be able to explain how this applies in your case.
With a basic understanding of the state pension system out of the way, we can now explain the deferred pension and its pros and cons. As you read, please understand that every situation is different. What applies in your case may not necessarily apply to someone else.
Deferring Your State Pension
If you do not need to begin collecting state pension payments at the point you reach state pension age, then you may choose to defer those payments. You have two options for doing so. The first is a weekly option while the second is annual. These work as follows (under the current system set to expire in 2016):
- Weekly – Under this option, you earn an additional 1% for every five weeks you defer. Should you defer under this option for two full years, you would receive almost 30% more every month, adjusted for inflation. This is quite a substantial increase by any measure.
- Annually – Under this option, you can receive a taxable lump sum for deferring state pension payments for a year. The lump sum payment would be equal to the amount of money you would have received in weekly payments, plus interest at 2% higher than the current base rate.
As you can see, the two options give you quite a bit of flexibility with your state pension. Electing to defer under the first option means more money received for the life of your state pension payments, while option two provides a bit of extra cash you might use for something you have always wanted to do.
Pros and Cons of the Deferred Pension
So, why would you want to defer state pension? And if you did defer, what are the pros and cons? You will start with the benefits of the deferred pension. The most obvious benefit is the ability to receive more money simply by delaying the start of your weekly payments. More money is always a positive motivation in retirement. Other benefits of the deferred pension include:
- Higher Returns – A 1% increase for every five weeks of deferral may not seem much, but it is a far better rate of return than you would get from a savings account. Delaying payments for 12 months works out to 10.4% – an average of £612 annually for most – as opposed to less than 2% per year for the average savings account.
- New State Pension – The introduction of the new state pension in 2016 has no bearing on your deferred pension plans. Deferring will get you more money whether you retire under the old rules or the new.
- Continued Working – There are those who choose to defer pension payments while they continue working for a few years after reaching state pension age. These additional working years also come with additional insurance contributions that, in the end, will increase your state pension payments even further.
- Financial Management – There is always the temptation of spending more than you should if your retirement income is higher than your bills. A deferred pension can be a good financial management tool by temporarily reducing the temptation to spend excessively. If you are not receiving the money, you cannot spend it.
It should be obvious that the deferred pension is not the best option for everyone. In fact, there are some definite downsides to this strategy. These are as follows:
- Less Income – Obviously, deferring your state pension payments will result in less income throughout the year. Based on the basic state pension amount, that works out to more than £5,800 less. You will need to make up that income elsewhere.
- Delayed Benefit – Although the financial benefit of deferring your pension is very real, it takes about ten years before the additional income is realised in real terms. You may have to weigh that against any health conditions that might increase your chances of dying within the 10-year window.
- New Rules – The new rules due to be applied from April 2016 cut the rate of increase from 10.4% to 5.8% for those who choose the weekly deferral option. At 5.8%, it may not be worth it, especially if your other sources of retirement income are just barely enough to pay your bills.
A deferred pension may be very good in your circumstances if you have sufficient retirement income provided by other pensions and investments. Delaying receipt of your state pension payments ultimately gives you more income once you decide to start receiving them. However, the deferred pension may not be a good idea if your other sources of income are not reliable. In the end, it comes down to analysing every aspect of your personal circumstances against the possibilities of the future.
There is no way to guarantee that a deferred pension will always pay off, so be sure to consider all your options carefully. Choose that option that best fits your retirement goals.
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