What does rising inflation mean for pension schemes?

The United Kingdom is currently experiencing high levels of inflation and economic uncertainty. The Consumer Prices Index (CPI) rose by 10.1 per cent in the 12 months to July 2022, the highest annual CPI inflation rate since 1982.

According to press reports, this could increase further in the coming months. Trustees of defined benefit (DB) occupational pension schemes and their sponsoring employers should be preparing themselves for queries and challenges from members on what they are doing in response.

How do DB pensions increase?

DB pensions that are in payment will usually increase annually at a level in line with inflation. However, the amount of these increases is typically capped and will often vary depending on when the benefit was built up and between classes of members.

Statutory minimum annual increases for pensions in payment were first introduced on 6 April 1997, and originally limited to inflation capped at five per cent. Pensions earned on and after 6 April 2005 currently increase by reference to CPI capped at two and a half per cent.

Active members of DB pension schemes that are still open to future benefit accrual (and the limited number of deferred members of closed DB schemes who remain in service and retain a link to their ‘final salary’) will benefit from some inflation protection for their salary-linked benefits through salary increases, provided those increases are pensionable. The level of protection provided will depend on the salary increases awarded, which may not track inflation.

For deferred members (i.e., those who are not accruing any further DB benefits), legislation requires their DB pensions to be revalued pending payment (known as ‘deferment’), but like the minimum pension increases noted above, statutory minimum revaluation rates vary depending on the period benefits were built up and the date the member left pensionable service.

Since 6 April 2011, the statutory minimum final salary revaluation increase is CPI capped at 2.5 per cent per year for pensions earned on and after 6 April 2009, or generally 5 per cent for pension earned before that date.

In contrast to pension increases, the statutory revaluation cap is not tested against the rate of inflation annually, but over the whole period of deferment. This means that a deferred member with a relatively long period of deferment spanning a period of low inflation may have built up ‘headroom’ against the cap, so that a one-off year of high inflation can result in a material increase to their benefits.

In some cases, this could mean a member considering retiring early might receive a significantly larger pension by deferring retirement until 2023. With this in mind, trustees may feel it important to explain to members the impact inflation could have on the value of deferred benefits and how the timing of retirement can have a material impact on the amount of revaluation applied.

Discretionary increases

As members start to feel the impact of inflation, pension scheme trustees and sponsoring employers may find themselves under pressure to award discretionary increases in excess of what is provided for under legislation or their scheme rules.

Each pension scheme will be governed by its own trust deed and rules, each with distinct provisions relating to discretionary pension increases. For that reason, across different schemes, trustees and employers will not all be able to respond in a uniform way to the challenges resulting from high inflation.

Some scheme rules contain a specific requirement for the trustees and/or the sponsoring employer to review scheme benefits and to decide if discretionary increases should be applied. Sometimes that requirement is described as an annual obligation, while sometimes it is expressed as a requirement to undertake such a review ‘from time to time’. Other scheme rules do not contain such a requirement at all but instead contain a more general power to ‘augment’ member benefits provided that certain conditions are met.

This means that some trustees will have power to make changes to member benefits and some will not. Even if changes could be made, there is a separate question about whether they should be, given the funding position of the pension scheme in question and the covenant position of its sponsoring employer. It will be important for trustees and employers to consider their schemes’ specific provisions before making any decisions regarding discretionary increases or communicating with members.

What should trustees be saying to their members?

Trustees should consider whether it would be helpful to explain to members the impact of inflation on their pension scheme and their benefits and any actions being taken in response. Consideration should also be given to whether a joint approach with the scheme’s sponsoring employer would be appropriate so that messaging is consistent.

Generally, trustees do have a duty to explain their scheme’s benefit structure to members, but are not required to warn members about actions which may be to their financial gain or detriment. In fact, recommending particular actions as to the exercise of options could constitute financial advice, so any communications should focus on generic explanations.

Trustees should also consider whether members will expect similar communications in the future. Will the trustees continue to communicate to members about the impact on the scheme in comparable situations, or can this instance be justified as a ‘one-off’?

What about DC pension schemes?

Members of defined contribution (DC) pension schemes will also be impacted by high inflation. Will their savings’ returns keep pace with inflation? If not, long-term retirement income will be negatively affected. In retirement, many annuities purchased with DC savings will have little or no inflation protection.

A prolonged period of high inflation may see a new set of challenges for members making use of retirement freedoms by flexibly accessing their DC pension savings. With many people now self-managing drawdown, retirees face a difficult choice between drawing down more now in order to maintain their current standard of living and trying to preserve their savings for use in later years.

The danger of withdrawing savings earlier than you might otherwise have done is that those savings stop working for you and you miss out on the potential for future growth. Withdrawing money early from your pension savings may also have an impact on the amount you can pay into your pension savings later (should you be in a position to do so).

DC members saving modestly is hardly a new phenomenon. However, the future impact of this is amplified in a high inflation environment and creates a real risk that an increasing number of people will not have saved enough by the time they come to retire.

Final thoughts

A prolonged period of high inflation will have a wide range of impacts on both DB and DC pension arrangements. In addition to the direct impact on members’ benefits noted above, trustees and sponsoring employers of DB schemes will also need to consider the impact on their schemes’ funding levels, investment strategies, covenant and journey plans.

Trustees should also be asking their actuarial advisers to confirm whether the terms on which cash equivalent transfer values, conversion to tax-free cash at retirement and early and late retirement are calculated remain appropriate. On the DC front, employers and trustees should be thinking about what steps they can take to increase member engagement with their pension savings with a view of maximising their value. This could include facilitating access to guidance on investment and retirement options.

Nigel Cayless is senior counsel at Sackers sackers.com