In a bid to improve and protect DB pension schemes the Government is toying with the idea of changing the way the DB pensions are indexed for inflation. Are you ready to take a reduction in your annual DB pension increase?
On the 20th of February, the UK Government published its Green Paper “Security and Sustainability in Defined Benefit Pension Schemes”. The paper brings forward concerns and issues regarding DB pensions and their future regulation.
In the paper, the government offers for consultation the possibility of letting ‘stressed’ businesses give pensioners less generous annual rises.
In simpler terms, the government is playing with the idea to let employers who are struggling financially reduce annual inflation-linked increases to pensioners.
How Could Employers Reduce Minimum Annual Pension Increase?
There are currently about 6,000 defined benefits pension schemes in the UK. They have around 11 million members and £1.5tn of assets under management.
Under the present regulation pensioners on DB schemes get a minimum annual increase in their pension which is linked to the retail prices index (RPI).
The government instead suggest that in some circumstances employers might be allowed to link year on year pension increase to the CPI to ease the burden.
It’s worth keeping in mind that the government already eased the burden for itself in 2011 by linking state pensions to the CPI. Another important thing to remember is that the burden is not really ‘eased’, – it is in fact passed on to pensioners.
DB Pension Schemes Under Pressure
Employers with DB schemes complain that the present arrangements are straining their resources. Two-thirds of defined benefit schemes are now in deficit., and the situation is getting worse.
“While we agree with the DWP’s conclusion that the majority of employers should be able to continue to fund their schemes and manage the risk their schemes are running, the PPF’s modelling does suggest that in the worst 10% of outcomes around 1000 sponsors could be insolvent by 2030.”
Jon Hattchet, Head of Corporate Consulting
Last year pension experts Hymans Robertson published a report saying that the UK’s combined DB deficit could be reduced by £175 billion if all schemes were to switch from RPI to the CPI. Such a switch would also reduce the benefits of an average DB scheme participator by £20,000.
This looks like a substantial reduction, indeed. However, in the light of gloomy predictions for many struggling DB schemes sponsors, there is another meaningful number to consider: if a sponsor fails completely and the scheme goes under the Pension Protection Fund management, members’ benefits are reduced by £45,000 on average. In this case switching over to the CPI indexation to help out a struggling employer doesn’t look like such a bad idea.
RPI vs CPI and What It Means for Your DB Pension
The RPI is an arithmetic mean that calculates the average spending of most private households. Retirees and those whose income falls into top 4 percent are excluded from RPI. The index includes mortgage interest payments, council tax and other housing costs.
The CPI, however, is a geometric mean. The way the CPI is calculated means that it is always below (or very rarely equals) the RPI. It also excludes housing costs.
It’s no wonder that the government prefers to link the payments it makes (pensions and so on) to the CPI and the payments it receives (taxes and so on) to the RPI.
Will All DB Pensions Be Reduced?
For now, the Government’s Green Paper on DB pensions is just an idea and a point for debate. Even if the switch is implemented, it will concern only some of the employers. However, in the present economic conditions, the number of struggling sponsors can turn out to be surprisingly high and can affect many Britons.
Abbey Wealth ‘Pension Tinkering’ Warning for Retirees Abroad
Calvin Thomas, managing partner in Abbey Wealth – Expatriate Wealth Management Advisory – commented, that if DB pensions are linked to the CPI, this will, of course, mean that those in retirement can expect a lower level of income for their retirement than they were anticipating. For retirees abroad it could potentially be “another reason to be switching away from DB schemes and into a QROPS”, – said Thomas.
So if you are planning to retire abroad, then to protect yourself from a low pension indexation, you might want to consider QROPS as an option.
See Abbey Wealth Pensions for further information about QROPS.