How a small change in calculating inflation will have big consequences for your pension
The way of calculating inflation relating to defined-benefit pension schemes is being changed from RPI to CPIH. Here's what it could mean for you.
When it comes to pensions, changes to the small print can have big ramifications. So it is with the announcement last week from the chancellor that the government is to stop using the retail price index (RPI) measure of annual inflation from 2030. Instead, Rishi Sunak said, the default inflation yardstick will be the consumer prices index plus housing costs (CPIH).
There are good reasons to make this change. Statisticians have long complained that the RPI does a poor job of measuring the way prices are really changing, frequently overstating inflation. But the move will have a profound effect on pensions – particularly on defined-benefit (DB) schemes.
Since these schemes have liabilities that grow broadly in line with inflation, they tend to make large investments in index-linked gilts, government bonds that pay an income linked to inflation. From 2030, returns on these gilts will depend on the CPIH measure of inflation rather than RPI. Historically, CPIH has, on average, been 0.8% below RPI inflation.
Expect more deficits
On this basis, the independent Pensions Policy Institute (PPI) calculates that DB schemes will be £60bn worse off once the switch comes into force. They will have to ask employers for larger pension contributions, and possibly make the same request of employees. It will also increase the odds of funds slipping into deficit, exposing members to the risk of a reduced pension if their employer goes bust before it has made up the shortfall. A second problem for many DB savers is that their schemes often promise to raise pensions in retirement in line with inflation. So yearly increases are likely to be smaller from 2030.
Over time, the effect of that change will be significant. The Trades Union Congress estimates that the average male worker with a DB pension from a private-sector company will be £11,000 worse off over the course of his retirement because of the move from the RPI to the CPIH. For women, who have longer life expectancies, the average loss will be £14,000.
The PPI’s analysis is similar. It reckons a 65-year-old male member of a defined-benefit scheme could expect to receive an average annual pension of £6,300 under RPI over the next 20 years. But the change in 2030 reduces this figure to £5,500.
These are significant reductions that will apply to large numbers of people. While employers are steadily closing down defined-benefit schemes, according to official statistics there are still 1.2 million people paying into such plans in the private sector, plus around 9.6 million more with deferred benefits or already receiving pensions.
However, some DB scheme members may be able to avoid lower pension increases. Where their scheme documentation makes a specific promise to raise pensions each year in line with the RPI – rather than a more generic promise to increase in line with inflation – the scheme may be legally bound to keep doing so, even after the government change.