Pension Deferral With Reference to Actuarial Fairness, Cost Neutrality, and Adverse Selection; a UK Perspective

Abstract

Persons who are eligible for a defined benefit social security pension may defer their pension and receive, through accruals, an extra pension or possibly a lump sum, on termination of deferral. In certain cases, partners of the deferrer may inherit such benefits. For such a scheme, the concept of actuarial fairness to a category of pensioners is defined. A scheme that is actuarially fair will not be cost neutral to the pension provider 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 provider. Expressions are derived for the cost penalty to the provider 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 provider, expressions for the cost to the deferrer are obtained. Some numerical examples are given in the case of the UK state pension scheme. Under present rules it is shown that there are significant departures from actuarial fairness, particularly for those who achieved state pension age before 6 April 2016 and those with partners eligible to inherit benefits. Even when a pension provider attempts to achieve either actuarial fairness or cost neutrality, if adverse selection is ignored, then significant departures from both are quite possible.

Keywords: pension, deferral, actuarial fairness, cost neutrality, adverse selection

JEL Classification: G22, H55, C02, C41, C44