Spectre of deflation looms large over pension provision
The forecast onset of deflation will have implications for pension provision, notably in relation to pension increases and revaluation. But it is unfamiliar territory. We examine some of the issues that will arise.
On this page:
Forecast of inflation
State pensions
Increase to DB pensions
Revaluation of deferred pensions
Annuity problems
Our research.
Key points
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The annual change in the retail prices index (RPI) was zero for February and is forecast to be negative throughout the latter half of 2009. It is the first time the UK has experienced no inflation for almost 50 years. Deflation will affect increases to pensions in payment, the revaluation of pension benefits prior to them coming into payment and some annuity rates.
Published material on pensions and deflation appears sparse, but the National Association of Pension Funds (NAPF) did produce a booklet1 on the subject 10 years ago, much of which is still pertinent.
Forecast of inflation
According to the Treasury's pre-Budget report, produced in November 2008, the RPI is expected to be negative for the rest of this year. The consumer prices index (CPI), which importantly includes housing costs and mortgage interest payments, is expected to remain above zero.
However, it is the RPI that is most important in a pensions context. State pensions are linked to the RPI currently (although they will be tied to national average earnings from some future date). The statutory increases to defined-benefit (DB) occupational pensions and the revaluation of deferred DB pensions are also dependent on the RPI, not the CPI.
The latest pre-Budget report states: "in addition to the [general economic] factors pushing CPI inflation lower, further declines in house prices and interest rates, in line with market expectations, put downward pressure on the measures of housing depreciation and mortgage interest payments included in the RPI. As a result, RPI inflation is forecast to fall below -2% in the third quarter of 2009." However, it adds: "This period of negative RPI inflation is expected to be relatively brief, with RPI inflation moving above zero again in 2010 as these additional downward pressures recede." It forecasts that RPI inflation will be +2.5% by September 2010.
Actuarial consultancy Punter Southall expects the cost of living to fall more for pensioners than for those of working age due to expected sharp drops in fuel and food prices, which make up a disproportionately high percentage of expenditure for those over retirement age.
State pensions
As noted above, the basic state pension increases in line with the RPI. However, in 2001, when the increase on this basis would have produced a very small rise as inflation was particularly low, Gordon Brown, as chancellor of the exchequer, committed the government to a minimum increase of 2.5% per annum. The pre-Budget report of that year set out the new rates to apply, and stated: "subsequently the basic state pension will rise each year by 2.5% or the increase in the September retail prices index, whichever is higher."
That commitment was open-ended and commentators have wondered whether the guarantee of a minimum increase might be withdrawn for the state pension increases due in April 2010. That increase will be based on the September 2009 RPI figure, which the pre-Budget report forecast will be -2.25%.
However, in February this year Secretary of State for Work and Pensions Rosie Winterton told the Commons: "Decisions on uprating for 2010/11 [ie the uprating in April 2010 based on the September 2009 RPI] will be made later in the year, but the government [has] already made a commitment to increasing the basic state pension by at least 2.5%. Should inflation fall to a negative figure next year, I can assure the House that we would not be looking to reduce current benefit levels." If inflation is indeed -2.25% in September, then an increase of 2.5% in the basic state pension will amount to a 4.9% increase in real terms.
Entitlement to earnings-related state pension is revalued in line with national average earnings, which are still showing a positive increase. However, if earnings fall, accrued second-tier pension could also conceivably be reduced before it comes into payment. In addition, the earnings-related pension rises in line with the RPI once in payment but there is no guarantee of a minimum increase.
Increases to DB pensions
It is most unlikely that pensions in payment being made directly from occupational schemes can be reduced. However, most pensions accrued under defined-contribution (DC) schemes will have been secured with an annuity, which we deal with separately below.
The law firm Slaughter and May expects that very few trust deeds and rules will have been written so they permit reductions to pensions in payment when the relevant RPI figure shows a fall. Furthermore, no reduction is permitted by law in respect of DB pensions based on service from April 1997 when limited price indexation (LPI) began to apply. LPI originally required pensions in payment to be increased in line with RPI inflation subject to a maximum increase of 5% per annum, a maximum since reduced to 2.5% per annum. That legislation does not permit a reduction in times of deflation.
Slaughter and May says that, even if scheme rules could technically be read as permitting a reduction for pre-April 1997 pensionable service, most schemes are likely to have had "a long history of communicating with members on the basis that they receive annual increases". It is unlikely that schemes will have mentioned the possibility of a reduction in pension in their communications. This is likely to raise further difficulties for any attempt to reduce a pension in payment.
Most increases to occupational pensions are made in January or April, generally using the RPI figure for either the previous September or December. Consequently, the implementation of any reductions is unlikely to occur for some months.
According to Punter Southall, a typical final-salary scheme with £100 million of assets would face extra liabilities of £0.5 million to £1 million were it not to reduce final-salary pensions. This could mean extra contributions of £90,000-£175,000 per year. This is based on the estimates of RPI included in the pre-Budget report, an average recovery period of seven years and interest rates of 6% per year.
Schemes that provide minimum annual increases to pensions in payment (often of 3%) will face higher additional costs.
Revaluation of deferred pensions
Deferred pensions from final-salary schemes are revalued in line with the RPI, generally capped at 5% per annum (although some schemes, notably in the public sector, have no cap). While the leaving-service pension cannot be reduced, revaluation is measured by reference to the aggregate RPI increase over the period in deferment - thus, in principle, periods of deflation will reduce the increase that would otherwise have been applied.
This may have an impact on members' decisions. Deferred pensioners who are able to request payment of their pensions may be well advised to do so before the decline in the RPI reduces their preserved pension. On the other hand, scheme members who are considering leaving their job (possibly accepting voluntary redundancy) will need to consider that they will not initially benefit when the RPI starts to rise again as increases will need to offset any earlier RPI falls. How individuals are affected will depend on when members leave pensionable employment and the extent of deflation in September.
The effect of deflation on the revaluation of benefits in career-average schemes will depend on each scheme's rules, according to Slaughter and May. Many schemes will provide some form of "floor", so that revaluation of members' benefits cannot operate negatively, but it will then be important to see whether this "floor" operates in respect of each individual year's RPI figure or as an overall protection. In any case, some active members of career-average schemes may be close enough to pension age to have an incentive to take their pension before falling inflation is reflected in its value.
Annuity problems
Members of DC occupational schemes and of personal pension and stakeholder plans will not be directly affected by deflation prior to retirement as their pensions will be based on investment returns. However, in most cases an annuity will be purchased at retirement. Where annuities are linked to inflation, Punter Southall confirms that pensions will typically reduce if annual inflation is negative in the appropriate month. This is specifically permitted by HM Revenue & Customs' Registered Pension Schemes Manual.
Where occupational schemes have bought out benefits with a bulk annuity, pensions should not fall, as policies should replicate the benefits that would have been provided by the scheme. However, Punter Southall is aware of deals where the possibility of deflation was only considered at the eleventh hour, so it is possible that in some instances such annuities could also reduce if deflation persists.
1 "The Impact of Deflation on Pensions and Pension Funds", by Roger Bootle, published by the National Association of Pension Funds in 1999, but not now available.
Our research
This feature is based on our own knowledge of pensions, supplemented by forecasts in the pre-Budget report 2008, information provided by the Department for Work and Pensions press office, the NAPF publication referenced and helpful conversations with partners at Slaughter and May and with Andrew Dodd, a senior consultant at Punter Southall. We also looked at the Financial Services Authority's occasional paper 14 on low inflation (OP, September 2001), which is available on its website, although this does not really address deflation.
