Rising inflation could create problems for DB schemes who have discretion to award inflation-linked increases.
Aon points out that with inflation rising sharply granting higher payments could add £8bn of liabilities across private sector DB schemes.
Most pension schemes award an annual inflation-linked pension increase, but this is typically capped at 5 per cent a year. However it is expected that inflation will remain above this for most of the year. Aon says that it usually inflation figures for September that are key to determining the following year’s increase. It said schemes will need to know who has the discretion in their scheme rules to decide whether or not to provide increases above the cap.
Aon partner Lynda Whitney says: “A potentially tricky situation is looming and schemes need to be clear from a governance perspective on where the decision sits. Is the discretionary increase power with the trustees, the sponsor or a combination of the two? Even if either party has unilateral power, reaching a consensus will often be desirable.
“It’s possible that some schemes could justify that they have been receiving significant deficit contributions to meet the guaranteed benefits and do not see the current scenario as a reason to provide a benefit improvement.”
The last time RPI was over 5 per cent was back in 2011 – and schemes were typically in a very different position at that time. Schemes’ technical provisions deficits are now much lower – and in some cases, there are technical provisions surpluses.
However, Aon points out that there are also some other notable differences:
- Schemes are now trying to head for long-term targets and most are still significantly short of reaching them. Any discretionary increases could lengthen the time to reach those targets, thus reducing security for members.
- Schemes’ inflation hedging levels are now much higher. This means that in some cases, the assets will be increasing slightly faster than the liabilities, as the hedge may not have fully allowed for the cap.
- In 2011, inflation only briefly moved above 5 per cent and then quickly lessened, so it was not a factor that was high in the public consciousness. This time, some of the causes of inflation, such as the cost of energy, will hit pensioners particularly hard.
- The UK State Pension is currently expected to go up by the ‘Triple Lock‘, which does not contain a cap. This has the potential to drive pensioners’ expectations of pension increases elsewhere.
Whitney adds: “It is logical for schemes not to pay the benefit improvement of discretionary pension increases and to progress faster on the journey to their long-term target. But there could be much more public demand now for discretionary pension increases than there was in 2011.
“For members with elements of pension that receive no guaranteed increases – for example, those with only discretionary increases on pre-1997 accrued benefits – the impact of inflation eroding the benefit will be even more significant.
“For example, with inflation at 2.5 per cent a year, the buying power of this type of pension will halve in 28 years; with inflation at 5 per cent a year, it will halve in 14 years; at 7.5 per cent a year, it would halve in just nine years. But this is a feature of the benefit design and does not necessarily imply that it is a pension scheme’s responsibility to help manage it.”
Whitney adds: “Overall, trustees and sponsors will need to look at their complete long-term funding plan and understand how guaranteed and discretionary pension increases fit within it and make decisions accordingly. But they may also need to be ready to explain to members how they have reached their decision on whether or not to grant a discretionary pension increase.”
