With rising costs across energy bills, mortgage repayments, travel costs and food bills – just to mention a few – the majority are feeling the pinch. And things are likely to get even worse, with energy prices expected to increase a further 65 per cent in October and interest rates going up as fixed mortgage deals expire.
At this time, pension scheme trustees are quite rightly asking the question: should they provide discretionary increases to pensions to assist members at this difficult time? But I worry, that while trying to do good, more will be added to the endgame cost than expected and/or delay securing members’ benefits with a provider.
DB pension arrangements partially protect pensioners by increasing pensions with inflation but are typically capped at either 5 per cent p.a. or more latterly 2.5 per cent p.a. However, statute didn’t require benefits accrued before 1997 to be inflation-linked (other than GMP), and many schemes pay no increases on this tranche of benefits. It’s this tranche of benefits, and those capped at 2.5 per cent p.a., that are more likely to be of concern to trustees in the current environment.
Discretionary increases are only applied to the pension for that next year (albeit that additional pension continues to be paid until death). A one-off 1% discretionary increase for a member with a £10,000 p.a. pension could cost just over £2,000 based on current life expectancy assumptions. Of course, this is only for one member and costs increase with scheme size.
In an insurance transaction, any discretionary practices need to be codified, so the insurer has more certainty over what they are insuring. Where a scheme has not offered discretionary increases in the past, the decision is potentially easy. Members who have no expectation of discretionary increases won’t miss what they have never had. Therefore, the insurer is often told no discretionary increases should be allowed for within their premium.
However, where schemes start to offer discretionary increases – especially those close to approaching the buy-out market for a quote – the position becomes less clear. Where members develop an expectation that discretionary increases are actually “guaranteed”, they may claim their benefits are being unfairly cut back – with the Pensions Ombudsman potentially getting involved.
In terms of cost, having to pay an extra 1 per cent increase every year on that £10,000 p.a. pension would be potentially 15 times more expensive than a one-off increase, costing over £30,000 – remember this cost is just for one member.
So how do scheme trustees avoid the risk of a one-off discretionary increase building an expectation from members for more increases in the future? Here’s what they should consider:
- What do the rules say? Many require a review of pension increases each year, which will determine how much thought you give the decision
- Who has the power to provide a discretionary increase? If sponsor consent is required, there may be strong reasons why a discretion shouldn’t be provided, independent of whether the trustees wish to help members or not
- What is the scheme/member dynamic? Some schemes have pension groups that proactively raise issues like discretions every year and will be much more sensitive to any decisions made. These groups can drive multiple complaints, leading to the hassle of dealing with many individuals coming forward to question any decisions made.
- Communication is key. Poorly worded communications when increases are granted can create an expectation, as can wording in member booklets. All communications should be carefully reviewed to make sure they correctly reflect the actual position
- Affordability. Don’t just look at the Technical Provisions impact, but also the impact on buyout costs and the scheme’s journey plan. In many cases, buyout is the ultimate cost of the scheme and most remain in deficit. So why add to that shortfall by adding cost?
- How long to buy-out? More care needs to be taken for those schemes close to buyout, where today’s decisions are more likely to impact eventual insurance costs.
If schemes do wish to provide a discretionary increase but avoid it creating an expectation, it is imperative the wording in any communications is carefully considered. This should not just reflect the decision and rationale, but also how it may be interpreted for future economic environments.
Many don’t start to think about the practical aspects of the endgame process until they are close to transacting. As a result, decisions can be made that either increase cost or make schemes less attractive to insurers, in an already competitive market. Trustees and companies should be making sure the advice they receive considers long-term implications, as well as shorter-term issues.
