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The Impact of Deferral and Adverse Selection on the Actuarial Fairnes and Cost Neutrality of the UK State Pension

Jon Dagpunar

Persons who have achieved UK state pension age (SPA) may defer their pension and instead receive an extra pension on termination of deferral. We define a scheme to be actuarially fair to a category of deferrer with agreed discount rate, when the expected net present value of pre-tax lifetime receipts is independent of the deferral period. After a review of the literature on deferral and early take-up of state pensions in the UK and other countries, this paper argues that the current UK scheme based upon a uniform accrual rate cannot be actuarially fair. Instead, we propose a scheme where the accrual rate is dependent upon deferral period, gender, SPA, deferrer’s discount rate, degree of pension uprating, and partnership status of the deferrer. Fair accrual rate curves are plotted for various scenarios and compared with the current uniform rates of 10.4% and 5.8% per annum that apply to those who attain SPA before 6 April and after 5 April 2016 respectively. A scheme that is actuarially fair will not be cost neutral to the Exchequer unless the discount rate is the same for both parties. In addition to this asymmetry, adverse selection will impact upon both actuarial fairness and cost to the Exchequer. Expressions are derived for the cost penalty to the Exchequer for attempting to achieve actuarial fairness both with and without an acknowledgement of adverse selection. Similarly, when the objective is to achieve cost neutrality for the Exchequer, expressions for the cost to the deferrer are obtained. Some numerical examples are given for various scenarios. The methodology should be applicable to public pensions in other countries, in order to inform fair policies for both early and postponed take-up of pensions.

Keywords: UK State pension, deferral, actuarial fairness, cost neutrality, adverse selection, discount rate