Finding yourself out of pocket

The recent announcement that pension increases will be linked to CPI rather than RPI could leave future pensioners out of pocket. Helen Morrissey looks at whether this will be the case and asks how the change needs to be managed

The recent decision by government to link pension increases to CPI as opposed to RPI from 2011 was music to the ears of many sponsoring employers. Historically RPI has always been higher than CPI meaning that these increases will no longer be as generous as they have been in the past. The potential savings that come with such a move have been estimated at anything between £25 billion to £100 billion – welcome news to those employers who have been struggling with soaring scheme liabilities.

Promises not guarantees

“At this time there are a lot of DB schemes in deficit and you only need one big scheme to go into the PPF for us to see the system fall like a pack of cards,” says Annuity Direct CEO Bob Bullivant. “If you want to take a balanced view of the recent changes then it is better for employees to have increases linked to CPI and have a more secure DB environment than for them to have increases linked to RPI and then have a less secure DB environment. It is the mantra of the government that we are all in this together and I think this is a neat way of sharing risk without completely upsetting the apple cart. If we can manage this then it must be a good thing as in the past any changes have usually been to the benefit of one party. We need to get members to realise that DB is a promise – not a guarantee.”

However, not all commentators were so upbeat about the potential changes and while employers have reason to celebrate, the news is less welcome to scheme members who are likely to see a demonstrable difference in their pensions in the years to come.

“These changes potentially amount to a considerable cost saving for companies but the result is that many scheme members will be less well off in retirement,” says Hammonds LLP partner Kris Weber. “These changes were introduced to help employers manage their defined benefit schemes. The fact of the matter is that many employers find themselves operating within a very different regime to that which existed when the scheme was first set up. Costs are now getting out of control and many employers can’t afford to keep them going.”

Weber is joined by several other industry commentators who warned of sizeable decreases in pensioners’ income. Most recently Standard Life’s Andrew Tully said that as a worst case scenario pensioners could find their income depleted by 25%.

What happens now?

So while employers can look forward to an easing in their obligations it is important to note that the transfer from RPI to CPI is unlikely to be straightforward. Employers and scheme trustees will need to comb through their trust documents to check how pension increases are to be treated. If no specific reference is made to RPI then the change to CPI can be made fairly easily. However, it is estimated that many DB schemes actually do make specific reference to RPI in their scheme documents. According to Hewitt scheme actuary Linda Whitney, the whole process could become difficult as employers will not be able to make the change automatically.
“Unless the government is prepared to override scheme rules then schemes won’t be able to take advantage of these changes automatically,” she says. “Until we know how these changes will be communicated then it’s difficult. However, those schemes that don’t specify RPI in their trust documents will need to make changes very quickly and so will need to get a communication strategy in place. Those with deferred valuation do not have to move so quickly.”

She continues: “We think anything from 10-27% of schemes will be affected by the change and it can get very messy. In theory we could end up with people attracting CPI increases from now until they retire and then having RPI linked increases post retirement. We have an issue where the same person is being treated differently depending on what stage they are at.”

She also points out that employers and trustees will need to look further than their trust documents when determining if they can make the switch. According to Whitney, schemes will need to assess their entire communications to ensure that they don’t contain any reference that raise member expectations that they may receive increases linked to RPI rather than CPI.”
Weber agrees that things won’t be straightforward and believes the DWP is underestimating the potential difficulties.

“We are effectively replacing what was a straightforward system with one that is not,” he says. “If you look at scheme rules some state pension increases increase by RPI while others rely on statute. How can you change the rules when RPI is stated? It’s going to be a very scheme specific exercise. However, the DWP seems to think it’s only a minor technical change – it isn’t.”

Overriding legislation and challenges

Indeed it would seem the DWP will need to brace itself for the waves of dissent spreading through the industry which have culminated in 25 industry professionals sending a petition urging the government to re-think the changes via pensions social network Mallowstreet. However, it’s important to note that it is still early days since the change was announced and full details have yet to be revealed.

“The big concern so far is over the lack of clarity surrounding the rules as they stand right now and how they can be applied across different schemes,” says KPMG’s pension partner Mike Smedley. “We also have to ask whether some schemes will be able to change their rules at all unless the government is prepared to introduce legislation to override what is currently in place.”

He also points to further possible complications that mean the changes may not always be good news for companies. One major issue is that if one business still has to pay increases linked to RPI they may well feel that a competitor has been given an unfair advantage if their scheme rules enable them to link increases to CPI instead. He also points to the fact that RPI does not always exceed CPI.

“In the long run as well you can’t be certain that RPI will remain higher than CPI,” he says. “If you look at September 2009 for instance RPI was negative while CPI stood at 1.1%.”

A further complication can arise when it comes to funding a scheme’s revised liabilities. While CPI linked gilts would be one way to fund the gap they are not attractively priced. Any further issuances would come from the Debt Management Office but they have said they will see how demand for the investments develops before deciding whether to issue more.

“At the moment, the pricing of CPI linked gilts is not particularly advantageous and no-one is likely to use them unless the price becomes more sensible,” says Whitney. “We are in something of a catch 22 situation whereby the Debt Management Office won’t issue these gilts unless there’s sufficient demand but the price is too high to stoke demand. We need someone to come forward and test the waters before the market takes off.”

Open dialogue

So what more can the industry do while it awaits final clarification of the rules? The answer according to AWD Chase de Vere’s technical director Param Basi is to start communicating with scheme members sooner rather than later.

“Whatever happens next needs to be transparent and people need to be prepared,” he says. “My view is that it doesn’t do an awful lot for people’s trust in pensions as a savings vehicle – it’s not well thought through from that point of view.”

Weber agrees that communication is vital if the changes are to be implemented properly.
“Employers and trustees need to be involved in the process and a lot of it will be down to how lawyers interpret the change,” he says. “There is also talk of overriding legislation to enable these changes to be made. However, do you also give the employer the right to bypass trustees? It’s a real small print lottery. I think you need an open and constructive dialogue and one good thing to come out of the last few years is that employers and trustees now work together more than they ever have before. An entrenched position helps no-one.”