Lump sum intended to encourage deferral of state pensions

As a result of changes introduced by the Pensions Act 2004, those who defer drawing their basic state pension for at least 12 months from April this year will be able to opt to receive a taxable lump-sum payment instead of increments on their eventual weekly pension. We explain how the new rules work.


Summary of key points

  • A lump-sum option has been introduced as an alternative to an enhanced pension for those deferring their state pension, and the enhancement is now more attractive.

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  • Increments to state pension are earned at the rate of about 10.4% a year after a minimum period of five weeks' deferral.

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  • The taxable lump-sum option that had been introduced requires deferral to be for at least 12 months.

  • The rate of return on the lump sum will be set at an interest rate of 2% above the Bank of England base rate and will change when the base rate changes.

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  • There is no upper limit on how long state pension can be deferred.

  • It is proposed that receipt of the lump sum in a particular tax year will not cause the taxpayer's marginal rate of tax to increase.

  • The lump sum is ignored for the purposes of means-tested benefits.

  • An individual who claims pension credit during a period of deferment will be treated as receiving his or her state pension entitlement for the purposes of the claim, but this does not prevent the accrual of increments or a lump sum.

  • Those deferring their state retirement pension are not required to be in work to qualify for a lump sum or increased weekly pension.

    The measures in the Pensions Act 2004 that introduce the changes to legislation governing the deferral of state retirement pension closely follow those set out in the earlier Bill . Those who have reached state pension age can choose to defer receiving their state entitlement or, if they have already begun receiving their entitlement, they can choose to suspend it. The entitlement that can be deferred includes the basic state pension, additional pension from the state earnings related pension scheme (SERPS), the state second pension (S2P) and graduated retirement benefit.

    Before April this year, such deferral would be rewarded by increments becoming payable on top of the then current rate of their pension entitlement. These increments were calculated at 1% extra for every seven weeks of deferral (or about 7.5% extra for each year deferred). Under the old rules, deferral was limited to a minimum period of seven weeks and to a maximum period of five years - therefore, to no later than age 70 for a man and 65 for a woman.

    It is estimated that currently 60,000 to 65,000 people have postponed claiming their state pension. The government hopes its changes will encourage more to do so and to work beyond state pension age.

    Changes introduced

    Following the amendments made by the Pensions Act 2004, from April 2005 those who defer their state pension for at least 12 months now have the choice of either:

  • a taxable lump sum based on the pension forgone plus interest, and the state pension payable without increments; or

  • increments calculated at 1% for every five weeks of deferral (about 10.4% extra for each year deferred) paid in addition to the state pension to which they are entitled.

    Those who defer for a minimum of five weeks but less than 12 months cannot take the lump-sum option but will still qualify for the increments. On the other hand, there is no longer any upper limit on how long state pension entitlement may be deferred.

    Both husband and wife may defer their pension entitlement, either by deferring their own category A pension, or as a consequence of one spouse deferring his or her own category A pension so that the other spouse's own category B or category A/B pension is deferred. If so, each half of the couple can choose separately to have increments or, providing deferral is for at least 12 months, a lump sum.

    Although the aim in introducing these changes is to encourage people to continue working after state pension age, there is no direct linkage. Those deferring their state retirement pension are not required to be in work to qualify for a lump sum or increased weekly pension.

    Apart from provisions in the Pensions Act 2004, the introduction of the new deferral rules have required changes to the secondary legislation. A summary of the changes made by recent Regulations is given in box 1.

    Calculating the lump sum

    How the lump option is calculated is best described through the use of the worked example set out in box 2.

    The rate of return used to calculate the lump sum is to be set at an interest rate of 2% above the base rate determined by the Bank of England and an alteration to this base rate will automatically trigger a corresponding change in the rate of return used for the lump sum in order to maintain the two percentage point differential. The intention is to apply any such new lump-sum rate from the beginning of the first accrual period (of one week) following a base rate change, but the legislation permits a longer lead-in period for implementing a new rate of return.

    Taxation of the lump sum

    The lump sum provided in lieu of the increments is taxable but it is proposed that such lump-sum payments will not be added to the rest of the pensioner's income to calculate his or her total income for tax purposes. Instead, the rate of tax due on the lump-sum payment, as proposed, will be the highest rate of tax that pensioner pays on his or her other income (ignoring any of the special rates of tax that apply to any savings or dividends that the pensioner also receives).

    The overall intention is to ensure pensioners who have taken the lump-sum option are not pushed into a higher tax bracket than that which would otherwise apply on their other income in that tax year. Pensioners' normal weekly state pension, paid once this has been claimed, is included in their other income for tax assessment purposes. Also, receipt of the lump sum will not affect pensioners' entitlement to the age-related personal tax allowances.

    Pensioners can also direct the Pension Service of the Department for Work and Pensions to make the lump-sum payment in the tax year after the tax year in which payment of their deferred state pension starts. This might be useful to them if their income in that following year is lower because they are no longer working and would be paying tax at a lower rate. The lump sum will be paid after the deduction of tax. Those choosing the lump-sum option will be asked to sign a declaration of their estimated income in the tax year the lump sum is to be paid so that the Pension Service knows what rate of tax to deduct.

    Effect on pension credit

    The lump sum will be completely ignored for the purposes of calculating the claimant's entitlement to pension credit, housing benefit and council tax benefit. In contrast, state pension, including the increments derived from deferral, will be treated in the same way as any other retirement income for the purposes of these means-tested benefits. The increments will also be included in any qualifying income for the purposes of calculating the pensioner's entitlement to the savings credit component of the pensions credit.

    Individuals may make a claim for pension credit during a period when they have deferred their entitlement to state pensions. Their entitlement to the means-tested benefit will be calculated as if that person were also receiving the state pension entitlement that would otherwise be due. This will not, however, affect individuals' right to defer their state pension and build up rights to increments or a lump sum.

    Death of the deferrer

    A detailed description of what happens to the deferred entitlement on a person's death is given in the Pension Service booklet SPD1*. Much depends on whether the person who deferred the entitlement is married and whether he or she dies before or after claiming the pension. Different rules will also apply to widowers from April 2010.

    Generally, if the deferrer dies before claiming, a surviving spouse will be able to choose to inherit either a lump sum or increments (subject to the 12-month rule) based on the deceased's deferred entitlement - although this is subject to qualification if the deferred pension is based on the survivor's own contributions. The survivor must have still been married to the deceased at time of death, must have reached state pension age and must have claimed his or her own state pension without having remarried before doing so.

    If the surviving spouse has not yet reached state pension when the deferrer dies, a lump sum, as nominally accrued at the date of death, will be increased annually in line with prices up to the date the widower or widow claims his or her own state pension. The calculation of the lump sum for survivors will reflect:

  • 100% of the increments or lump-sum payment earned by the deceased spouse on his or her basic state pension;

  • 50% of the increments or lump-sum payment earned by the deceased spouse on his or her additional pension from S2P;

  • 50% of the increments or lump-sum payment earned on graduated retirement benefit; and

  • between 50% and 100% of the increments or lump-sum payment earned on additional pension from SERPS.

    Views on these changes

    The Pensions Policy Institute (PPI) emphasises that, in evaluating the benefit of deferring state pension in order to take an eventual lump sum, individuals should compare the amount of the lump sum likely to be received with the cash accumulation that would arise if, instead, a pension was drawn and invested in a suitable deposit account. The two main factors are the likely difference between the two interest rates applied and the difference in the tax treatment.

    The PPI has estimated the potential gain from the lump-sum option on this basis for someone on a state pension of £105 per week (which is the average state pension for new male pensioners) who defers it for five years. Where there is no tax advantage, it calculates the actual gain at around £1,200. If this individual would have been taxed at 40% on the state pension (because he or she was still working), but would be taxed at 22% on the lump sum (because he or she had by then ceased work) the actual gain is calculated at around £7,500.

    The PPI says there is no such obvious incentive for the option of deferring and taking an enhanced pension. Much depends on whether the individual lives long enough to receive more in enhanced pension.

    * "Your state pension choice - pension now or extra pension later: a guide to state pension deferral", SPD1, available from tel: 0845 731 3233, free, or from the Pension Service's website (www.thepensionservice.gov.uk ) via "A to Z", "Deferring State Pension" and "Find out more about State Pension Deferral", where a link to the guide can be found towards the bottom of the page.

    "PPI briefing note no.19: The gain from deferring state pensions" available from the PPI's website ( www.pensionspolicyinstitute.org.uk) via "Briefing Notes".


    Box 1: New regulations on deferring state pension

    Social Security (Deferral of Retirement Pensions) Regulations 2005 (SI 2005/453)

    These Regulations provide for the accrual and calculation of lump sums and also amend existing Regulations on the calculation of increments, time limits for deferral and the manner in which state pensioners are allowed to stop claiming their state pension in order to build up entitlement to increments or to a lump-sum payment. The Regulations also make the existing overlapping benefit rules (which prevent increments, and now lump sums, building up if the pensioner is also in receipt of another contributory state benefit) consistent so that, for new claims from 6 April, a deferrer is prevented from earning increments/lump sum if the deferrer's spouse is in receipt of a dependency increase, which would have been abated if the deferrer had instead claimed his or her state pension.

    Social Security (Graduated Retirement Benefit) Regulations 2005 (SI 2005/454) (as corrected by Social Security (Graduated Retirement Benefit) (Amendment) Regulations 2005 (SI 2005/846))

    These Regulations effectively replicate the new arrangements applying to those who are deferring entitlement a category A and B state pension for those who are deferring entitlement to graduated retirement benefit.

    Social Security (Claims and Payments) Amendment Regulations 2005 (SI 2005/455)

    These Regulations provide for claims for a category A or B retirement pension or graduated retirement benefit to be made in advance of the date on which a period of deferment ends. They also provide that the time for claiming such pensions for any day on which the claimant is entitled to payment of them is the period of 12 months immediately following that day, instead of the period of three months beginning with that day. The 12-month period is being introduced gradually as a transitional measure.

    They further provide for claims for such pensions made on behalf of a person who has died and who was not married at the time of death. A maximum of three months' arrears may be claimed. Where there is a claim on behalf of those who deferred their entitlement during the 12 months before their death, that person will be treated as having made an election in favour of an increase rather than a lump sum in respect of the deferment.

    Social Security (Retirement Pensions etc) (Transitional Provisions) Regulations 2005 (SI 2005/469)

    These Regulations modify these provisions for those who had already started deferring their state pension on 6 April 2005, in order to: (i) establish the period for which the lump sum is to be calculated; (ii) allow lump sums to be calculated in a different way to that set out in the Pensions Act 2004, where this would be beneficial to the claimant; (iii) simplify the transition from the old to the new rate of increments; and (iv) enable increments to be awarded for the pre-6 April 2005 period where the normal de minimis rule would be breached as a consequence of a person choosing a lump sum for the period 6 April 2005 onwards.

    Social Security (Inherited SERPS) (Amendment) Regulations 2005 (SI 2005/811)

    The principal Regulations allow for the inheritable proportion of a deceased person's additional pension from SERPS to be reduced gradually from 100% to 50% between October 2002 and October 2010. These amending Regulations modify in the same way the calculation of the proportion of a lump-sum payment that is accrued in respect of a deceased deferrer's additional pension.


    Box 2: Example of how the lump sum accumulates

    The following example demonstrates how the lump sum accumulates. The weekly pension rates and rate of return shown here are illustrative only.

    Assume Miss Smith would have been entitled to state retirement pension of £100 per week from April 2005, had she claimed at that point, and that the prescribed annual interest rate at the start of the period of deferment was 6%. This is equivalent to a weekly increase factor of 52Ö1.06 or 1.001121 and is based on an assumed Bank of England base rate of 4%*.

    At the end of the first accrual period (week 1), the amount accrued would be:

    (£0.00 + £100) x 1.001121 = £100.11

    (Note that in the first week, there is no "accrued amount" to bring forward from the previous week, therefore this is shown as zero.)

    At the end of the second accrual period (week 2) the amount accrued would increase to:

    (£100.11 + £100) x 1.001121 = £200.34

    At the end of the third accrual period (week 3), the amount accrued would increase to:

    (£200.34 + £100) x 1.001121 = £300.67

    After 52 weeks, Miss Smith would have accrued a lump sum of £5,357.49.

    Assume that Miss Smith continues to defer and that her retirement pension entitlement increases to £103 with effect from April 2006. The lump sum will continue to be calculated in the same manner as above, except that £100 changes to £103. At the end of the first accrual period using the new rate the lump sum would be:

    (£5357.49 + £103) x 1.001121 = £5,466.61

    At the end of the second accrual period using the new rate the lump sum would be:

    (£5466.61 + £103) x 1.001121 = £5,678.85

    If Miss Smith chose to defer for two years altogether, at the end of March 2007 she would be entitled to a lump sum of £11,197.15.

    * Note that in practice the current annual interest rate of 6.75% is based on the Bank of England's base rate (the repo rate) of 4.75% (which was reconfirmed on 19 May 2005) and so, for example, at the end of the third week the amount accrued would have been £300.75 rather than £300.67.

    Source: Explanatory notes to the Pensions Act.


    Our research

    This feature draws primarily on the Pensions Act 2004, the accompanying explanatory notes, the Deferral of Retirement Pensions Regulations 2005 and the Pension Service guide "Your state pension choice - pension now or extra pension later: a guide to state pension deferral". We have also drawn on the commentary from the Pensions Policy Institute.