How inflation will hit your pension savings
Many pension schemes that offer protection from price rises aren’t as good as they seem, says David Prosser.
Millions of pensioners with supposedly gold-plated private-pension plans are going to take a big hit from inflation.
XPS Pensions, a pensions consultant, warns that more than four million pensioners in final-salary schemes and other plans offering guaranteed retirement benefits will not see their incomes rise in line with soaring inflation – now running at 10.1% – even though their schemes ostensibly offer inflation-proofing.
The problem is that while final-salary schemes promise inflation-linked annual pension increases to pensioners once they start receiving retirement income, the small print of most schemes imposes a cap on such rises. These caps, known as limited price indexation (LPI), typically restrict annual pension increases to 5%. Many pensioners will be unaware that their schemes feature LPI restrictions. Until inflation began to spike upwards at the end of last year, it had not gone above 5% since the early 1990s, rendering LPI caps irrelevant.
Now, however, LPI means many final-salary scheme pensioners will this year see their incomes go up by just 5% despite inflation running at more than twice that level; it is expected to rise even further in the months ahead.
Missing out on £25,000
Not all final-salary schemes impose LPI restrictions, but XPS’s analysis suggests around 4.5 million pensioners are currently in schemes that do feature such clauses, predominantly in the private sector. It suggests that the average 66-year-old pensioner will now miss out on £25,000 of income over their lifetime because of LPI, and also potentially face a squeeze on their household budgets in the short term as their income fails to keep pace with rising prices. Those considering taking early retirement over the next couple of years could be particularly hard hit, XPS warns. In some cases, the trustees of final-salary pension schemes do have discretion to make additional pension awards to pensioners.
However, many schemes will lack the funding to show such generosity – and, in any case, trustees must balance the interests of different groups of members, avoiding measures that could reduce the benefits available to future pensioners, for example. Still, the news is better for this last group. In most cases, the pension benefits earned by savers yet to retire and begin claiming their income are not affected by LPI clauses.
Instead, the incomes they have saved for so far do increase in line with the full rate of inflation until they reach retirement. The controversy over LPI is likely to mirror the row about the extent to which state-pension payments should guarantee inflation-proofing. The government’s triple-lock promise – that state pensions will rise by the highest of 2.5%, inflation or average earnings growth – was suspended last year as earnings rose sharply following the Covid-19 pandemic.
Ministers have since reinstated the promise, meaning that pension payments in 2023 will go up in line with the rate of inflation in September 2023, which is expected to be above 12%. That will impose significant costs on the Treasury, prompting complaints that older people are being given more support than other groups during the cost-of-living crisis.