Will Government strip inflation-based rises from final salary pensions?

8th November 2013

The government is shaking up pensions across the board but new proposals could see the value of final salary or defined benefit pensions slashed as employers may no longer be obliged to provide inflation linked rises each year John Lappin reports.

Ministers are also advocating a new type of pension – effectively an upgrade to existing defined contribution, which it is labeling as defined ambition schemes. But as with most reforms to pensions, an improvement for one group may come at a price for others.

Under defined contribution or DC pensions, what you get out as a pension depends on what you and the employer put in and of course stock market luck.

Some people believe that DC is quite an uncertain type of pension for an uncertain world. For a long time, many people were lucky enough to get a defined benefit pension, where after 40 years of service, employees would retire with an annual pension income worth about two-thirds of their salary at retirement.

Generally these pensions are provided by a big often long established employers, such as FTSE 100 listed firms. Yet with rising life expectancy, the pensions have had to be paid for much longer making the promises harder to fund. In a nutshell DB pensions have got more and more expensive to provide while the government has established all sorts of rules to ensure the pensions are paid as promised.

That explains why, generally, as employers have seen costs rise, DB pensions have been closed to new members or been closed altogether to new contributions. In more extreme cases, the pension liabilities have even been blamed for the failure of the businesses. It is a long and tortuous story over the last few decades.

What’s next?

But now the pension minister, Lib Dem Steve Webb would like to preserve some of the benefits of defined benefit and is hoping to encourage a half-way house plan known loosely as defined ambition though there are lots of sub-categories in the proposals.

However, under some of the proposals, he is also seeking to encourage employers to offer some guarantee of the amount of pension that will be paid out on retirement, in return for less regulation. That could be where the problems come in for some categories of DB members.

Webb said: “Final salary pensions have been in long-term decline and if we do not act it could disappear altogether. We want to help the best employers offer good alternatives including new forms of salary-linked pensions. We have looked at the best pension arrangements around the world and want to give British workers the chance to join such schemes. Our proposals for defined ambition pensions are designed to reinvigorate workplace pensions, providing people with more certainty about what they will get in retirement.”

The particularly controversial category is called ‘flexible defined benefit’. Now for hundreds of thousands of people in DB there is a risk you could see the value of that pension benefit reduced because companies may not have to make sure the pension payout rises in line with inflation. They may no longer have to pay to your spouse on the event of your death either.

These compromises may be extended to employers where the fund is likely to struggle to meet the cost of all the promises. Now under these proposals, this may only apply to future accruals i.e. how much you put in in subsequent years, not want you may have contributed so far but even this strikes Mindful Money as hellishly complicated to calculate.

But loosely, if the scheme does not have enough money, the Government is proposing to allow companies not to pay inflation increases to pensions, to increase scheme pension age i.e. the age at which workers can start taking the benefit. It may also reduce or remove the requirement to pay a pension to a spouse, when the original employee dies.

It follows on from the furore in 2011 over government legislation which allowed schemes to increase pensions in line with CPI rather than the more generous RPI. Over time, these changes of hugely significant.

In the words of Hargreaves Lansdown pension expert Laith Khalaf this may mean that “just as workers are about to reach that pot of gold, they may see it disappear off into the distance”.  He adds: “Under this new proposal, workers could save diligently throughout their lifetime, only for the rug to be pulled out from under them at the last minute. The government is trying to manage the decline of final salary pensions, but Flexible Defined Benefit schemes will be complicated, costly and will create huge uncertainty for pension savers about what pension income they can expect.”

Mr Khalaf has also provided some neat calculations of what inflation linking really means over the life of a pension. He says inflation-linking is an important part of final salary pensions, and workers probably don’t understand the full value of it.

A £10,000 annual pension adds up to £250,000 over 25 years without inflation increases. It would add up to £320,000 with inflation increases of 2% a year (i.e. assuming the Bank of England hits its inflation target); or £351,000 with inflation increases of 2.7% (the current level of CPI); or £416,000 with inflation increases of 4% (for instance if Quantitative Easing leads to a nasty bout of inflation). The government is proposing these changes apply to benefits built up in the future, rather than those built up to date. Companies may choose to continue to guarantee inflation-linked pensions, but the government is proposing that it won’t force them to.

This may be some way off. The Government has yet to change the legislation. Your employer would have to embrace it and propose the changes. Depending on when you joined the pension, it could apply only to a few years’ of service, so you may get a lot of inflation proofing. How other changes such as the date at which you can access the pension will change are still not clear. Nor indeed, whether only some of years of service would count for a spouse’s pension too.

But keep your eyes peeled. You may be about to lose out.

And if you are in a defined contribution arrangement, ministers are trying to bring a bit more certainty. That is, on balance, a good thing. But pension reforms always seem to involve winners and losers. It is shame there can’t be winners all round.

1 thought on “Will Government strip inflation-based rises from final salary pensions?”

  1. M says:

    Too little too late. Horse has long since bolted I’m afraid. Employers have been savaged by well meaning but ultimately bonkers and counterproductive regulation and taxes on pensions, that have added risk, cost, and volatility to their balance sheets. It is simply delusional to think that having been thus treated by Govt employers are going to take on volatile, undefinable risk stretching for quite conceivably a century into the future no matter how much the well meaning Steve Webb tinkers at the margins.

Leave a Reply

Your email address will not be published. Required fields are marked *