Should you defer your state pension?

Currently, pensioners who delay taking their state pension beyond the state pension age of 65 get a much higher payment, which rises by 10.4 per cent for every year deferred.

But under the new plans decided after the government took advice on what would be an actuarially fair rate, the uplift for anyone who turns 65 on or after 5 April 2016 and defers their pension will drop to a less generous 5.8 per cent a year. This gives retirees a 1 per cent increase for every nine weeks of deferral.

The reduced rate of increase means that someone choosing to defer for one year will now have to live for around 19 years to benefit from the decision, in terms of overall income paid, rather than 10 years under the current rate of increase.

The current deferral benefits are generous enough to make it relatively tough for pensioners, who are likely to have low risk appetites, to beat the extra income they provide by investing their undeferred state pension money instead.

To match the uplift provided by deferring state pension under the current system by investing, someone with a relatively long life expectancy would need to take on a high level of risk in order to generate high returns. If they live 20 years after retiring (to 85), they would need to invest their undeferred state pension income and get an average 9 per cent a year return. And if they lived 30 years (to 95), they would need to generate a 10.9 per cent average annual return on it to break even.

Alan Higham, retirement director at Fidelity, says people retiring before 2016 who believe that they will live a long time probably won't see investment returns beat state pension deferral.

But from 2016, retirees will find it much easier to beat the new, less generous state pension deferrals. Someone who lives until 85 will only need to produce a 3.3 per cent investment return to match state pension deferral uplift, while someone who lives until 95 will only need a 4.4 per cent return.

Nominal annual investment returns on invested undeferred state pension required to match deferred state pension (before 2016)

Source: Fidelity

Nominal annual investment returns on invested undeferred state pension required to match deferred state pension (after 2016)

Source: Hargreaves Lansdown

Tom McPhail, head of pensions research at Hargreaves Lansdown, said: "The reduced rate of increase now means that someone choosing to defer for one year will now have to live for around 19 years to benefit from the decision; this compares to only around 10 years under the current rate of increase of 10.4 per cent. This might still be an attractive proposition for someone in good health with substantial private savings or who is willing to carry on working. It is important to bear in mind that the old (current) rate of increases has been particularly generous."

But while state pension uplifts are guaranteed (unless the government change the rules), investment returns are not certain. Over the last year (to 30 June 2014), the average equity income fund produced a 4.5 per cent yield on a trailing basis, according to Sanlam research. However, UK equity dividends are due to rise by 5.4 per cent this year, suggesting investors could on the verge of receiving higher incomes. This would be welcome news for pensioners in income drawdown arrangements who are choosing not to delay their state pension.

Case study: State pension deferral post 2016

There may be instances in which deferring state pension and finding income from your investments can save you money. For example, Alan Higham, retirement director at Fidelity gives the example of someone retiring aged 65 post 2016 with a wife and grown up children. He has:

- Guaranteed income of £16,000 (state pension of £6000 a year & defined benefit pension £10,000 a year)

- A Sipp worth £300,000

- Essential expenditure of £18,000 a year

To make up most of the extra £2,000 they need to cover their expenditure, they could spend £54,000 of their Sipp money to buy an inflation-linked annuity of £1,872 (note this is based on July 2014 annuity rates and rates are likely to be different in 2016).

Alternatively, Mr Higham says they could save £30,000 by deferring their state pension for three years and spending £24,500 from their fund to cover their state pension payments. These would rise with inflation over that time. After three years they could take their state pension, by which time it will have grown to £7,872 a year in today's terms, giving them extra income of £1,872 a year.