Rising inflation eases pensions burden

Despite the Bank of England’s attempts to keep inflation low, pension schemes continue to experience higher levels of inflation.

This has helped reduce the expected cost of UK final salary pension scheme benefits by around £10bn over the last year, according to Aon Consulting, a leading pension, benefits and HR consulting firm.

Higher inflation reduces the expected costs of pension scheme benefits, because most schemes target investment returns linked to inflation, whereas a significant proportion of the benefits they pay out are often unrelated to inflation. For example, many schemes do not award full inflation linked pension increases. Therefore, although higher pension increases may appear favourable to pensioners, these increases are only designed to maintain the purchasing power (“real level”) of pension.

September is the key reference month for measuring annual inflation for most pension schemes. High pension scheme inflation has partly arisen because there are two measures of inflation, CPI (“Consumer Prices Inflation”) and RPI (“Retail Prices Index”), which are becoming increasingly disconnected.

The Bank of England sets interest rates to maintain low inflation of 2 per cent, as measured by CPI, which fell to 1.75 per cent over the year to September. Most UK pension schemes, however, target asset returns and award pension increases relative to the traditional measure of inflation, RPI, which was more than double the CPI figure at 3.95 per cent over the year.

Inflationary expectations play a key part in improvement of funding levels shown by the largest 200 UK pension funds in their company accounts at the end of October. There is an aggregate surplus of £3bn and 49% of schemes are in surplus. This is one of its highest funding levels since FRS17 was introduced in June 2001.

The analysis is the latest in the monthly tracker of aggregate net surplus (deficit) for the UK’s 200 largest defined benefit schemes, including all of those in the FTSE100. The month-end net surplus (deficit) since October 2006 for the largest 200 schemes is shown graphically below.

Commenting on these latest results, Marcus Hurd, senior consultant and actuary at Aon Consulting, said: “The Bank of England is successfully keeping Consumer Prices Inflation at around 2 per cent, but most pension schemes measure inflation using the Retail Price Index, which increased by around 4 per cent last year. This environment of higher inflation is easing the burden on UK pension schemes, because many schemes benefit from broadly inflation related investment returns while paying out benefits that are not fully linked to inflation.

“Higher inflation may appear like good news for many pensioners, who will receive pension increases of around 4% on part of their pension this year. In reality, however, this increase only ensures that their pensions do not lose value in real terms. Higher inflation actually erodes the purchasing power of any part of their pension that is not directly linked to inflation.”

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