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Pensions schemes: Inflated expectations

Pensions schemes: Inflated expectations

Why pension schemes might want to review their link to the retail prices index.

John Hodgson

Director, Pensions

KPMG in the UK


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Inflated expectations - red balloon floating

Some company pension schemes may be paying out significantly more than they mean to – or need to – because of the way they calculate annual increases. Trustees and company boards should think about reviewing whether they fall into this category, especially those facing funding pressures.

The issue is price inflation. Most mature businesses in the UK link their defined benefit (DB) pensions to inflation to offer retirees some protection against rising prices. The crucial question is which measure of inflation they use.

Historically, the Retail Prices Index (RPI) has been used across the board and for many that is stipulated in the legal drafting of the scheme. Others dictate the Consumer Prices Index (CPI) be used. However, in many cases, scheme rules are looser – putting the onus on trustees to determine the appropriate inflation index, either unilaterally or by agreement with the scheme sponsor.

It is this group that need to assess their position because the difference between RPI and CPI really matters. Technical differences between the two mean we generally expect future CPI inflation to run around 1% below RPI inflation (see chart below ).

Inflated expectations - graph 1

Source: ONS data

While 1% does not sound much, over the lifetime of a pension it could easily add up to a 10% difference in payouts. For schemes with a troubling deficit, this variation in pension liabilities could mean the difference between reaching or not reaching a secure and sustainable future.

It sounds like great news for schemes, but perhaps less so for pensioners. Might they not protest that such a move is merely a technicality that reduces their benefits and saves money?

That would be an unfair characterisation. Rather than seeing this as a “reduction” in pensioner benefits, instead switching to CPI may be an actual re-alignment of the scheme with its original intention – namely fair protection against people’s incomes eroding away.

Why is this an issue now?

Inflation linking has become a complex and important issue in recent years, for several reasons:

  • Pension liabilities are ballooning to levels never anticipated when the schemes were designed.
  • There is now a much better understanding of price inflation and the merits of different measurement indices.
  • An astonishing variety of legal wording used in scheme rules to describe the inflation link, has led to a number of subtly different legal challenges.

Why might the schemes have been overstepping their original intention? In recent years, an increasing number of economists have strongly challenged the statistical credibility of the RPI and have argued it overstates true price inflation.

The chart below shows an example pensioner who retired in 2007, aged 65, with an annual pension of £10,000. We assume here that future RPI runs at 3% a year and CPI at 2%.

Inflated expectations -  graph 3

In the intervening decade, the use of RPI has already increased the pension by £800 more than if CPI had been used. Carried through to age 90, the scheme would have paid out almost £40,000 extra as a result of using the higher inflation measure.

The cost to pension schemes under funding pressures is obvious. Pensioners rightly want a fair settlement. However, schemes must balance the interests of those who have already retired with the long-term health and viability of the scheme for members yet to retire. And don’t forget that CPI is now the headline UK measure of inflation and used for state pension increases, the statutory minimum for company pensions and many other purposes. It is undoubtedly a credible alternative to RPI.

So should our scheme move to CPI?

This debate only matters if your scheme’s rules permit a change and establishing that is the first step. If they do, then consideration turns to which index is most appropriate and whether a change should be made. This will require a constructive dialogue between sponsors and trustees. The topic is undoubtedly challenging, but the financial implications make it a difficult one to ignore.

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