Home ListingNovember 8, 2013

UK Pensions Face Inflation-Linkage Reprieve

<em>One of the least well-rewarded risks may be on the way to being removed for UK pensions.</em>

Reported by Featured Author

(November 8, 2013) — UK pension funds could see their liabilities slashed should proposals announced yesterday to cut inflation-linkage be confirmed.

A paper entitled “Reinvigorating workplace pensions” issued by the Department for Work and Pensions, highlighted a number of options the government might introduce.

One option was a lighter version of defined benefit (DB)“where employers offer a ‘core’ level of provision, with additional benefits above this minimum standard being discretionary”.

This “DB Lite” could offer:

“Conditional indexation – In this model, future indexation is not guaranteed, but is conditional on the funding of the scheme which is targeted at full revaluation. When the scheme is fully funded, the benefits would be increased in line with the scheme’s target index. When there is a funding deficit, the next year’s indexation would be withheld if the employer chose not to meet the deficit by making additional contributions. For years when pensions were not indexed, the resultant savings would reduce the funding deficit.”

And

“Optional indexation – This goes further by removing the statutory requirement for indexation, allowing employers to offer schemes that provide a pension not indexed to inflation.”

Existing liabilities would not be affected, but removal of inflation-linkage could see future commitments cut by a significant amount. Laith Khalaf, head of corporate research at financial advisory firm Hargreaves Lansdown, gave the following example:

“A £10,000 annual pension adds up to £250,000 over 25 years without inflation increases. It would add up to £320,000 with inflation increases of 2% a year or £351,000 with inflation increases of 2.7% (the current level of CPI) or £416,000 with inflation increases of 4%,” Khalaf said.

The move would not be unprecedented in Europe, where other nations are permitted to get around the problem of inflation uncertainty.

In Germany, pensions can avoid inflation indexing if they guarantee a 1% per annum increase, although this could be considered risky in the event of deflation. In the Netherlands, several of the largest pension funds have taken the option to remove indexation from their members’ benefits—at least temporarily—until their funding ratios are back on a steady footing.

For the full UK government report, click here.