The prospect of negative inflation in the months ahead — with the price of goods and services falling rather than rising — could put an extra £5bn funding pressure on DB schemes.
Unless there is a strong recovery in the economy between now and September, modelling by LCP suggests that CPI inflation could be negative in September, an in the worst case scenarios could be as low as -2.8 per cent. RPI may also go negative under some of these economic forecasts.
Negative inflation is a particular issue for pension schemes because pensions in payment cannot be reduced, even if inflation is negative. This means that negative inflation creates a ratchet effect for pension increases that in turn means that, in the medium term, pensions can now be expected to increase by more than inflation, which is a higher cost than has been budgeted by schemes.
September is often a key month for measuring inflation for pension scheme purposes, as it can affect annual pension uprating for the following year.
For example, LCP forecast RPI to be -0.8 per cent with a ‘steady as she goes’ recovery. With around £800bn in index-linked DB benefits in payment in occupational pension schemes, a 0.8 per cent increase in the real cost of benefits could represent a £5bn+ hit on schemes and their sponsoring employers.
CPI inflation has already fallen sharply from 1.5% in the year to March 2020 to 0.8% in April 2020. A further fall is expected when the inflation figure for May 2020 is published later this week.
LCP looked at likely inflation figures in three scenarios: a slower recovery with the economy ‘stuck in the doldrums’; a medium ‘steady as she goes’ recovery and a faster bounce-back recovery.
In the first scenario, CPI was likely to be -2.8 per cent, (and RPI -1.9 per cent). In the second CPI was likely to stand at -0.5 per cent (and RPI -0.8 per cent) and in the best-case scenario CPI would be 1.1 per cent (and RPI 1.6 per cent).
The impact on individual schemes will depend on factors such as the extent to which indexation of pensions in payment is linked to inflation, the reference month within the scheme’s rules that is used to assess pension increases, and the approach taken to hedging the pension increases.
LCP partner, Jonathan Camfield says: “Ultra low interest rates and market volatility has already weakened the funding position of many schemes, but negative inflation could add a further financial burden.
“Schemes generally cannot reduce pensions in payment even when prices are falling, resulting in a real-terms increase in the cost of providing pensions. We anticipate that this could add at least £5bn to long term scheme costs and the burden on their sponsoring employers as deflation is expected to be experienced in the economy over the coming months.”