Watson Wyatt warns over impact of negative inflation on schemes
UK - Significant rises in price levels are needed to stop negative inflation being used to calculate pension increases, Watson Wyatt calculates.
The consultant said - while retail price inflation over 12 months fell to zero in February, rather than turning negative as most commentators had predicted - a further 3.3% increase in the price level between the end of February and September would be needed to prevent negative inflation being recorded at the date most commonly used to calculate pension increases.
It warned in some cases a period of negative 12-month retail price index inflation could permanently increase the real value of some defined benefit pensions.
But it said that it could be possible that one year's deflation could be used to offset pension increases in the following year if a modest level of inflation returns.
With the impact of interest rate cuts and quantitative easing yet to be felt in full, and the VAT cut due to be reversed in January 2010, pension schemes may have to contend first with a period of deflation and then with a period of prices rising quickly.
Watson Wyatt head of defined benefit pension consulting John Ball said: "Tax rules make it unlikely that pensions would actually be cut but there is still a question about whether one year's deflation can be used cancel to out the next year's pension increases.
"If the scheme rules say this should happen, cost-conscious employers might not volunteer to pay for increases that do not have to be given. Trustees may also ask whether awarding pension increases above those required by the rules is fair on younger members, particularly if the scheme has a big deficit."
He added: "When the rules were written, no one really expected inflation to go negative. Accordingly, trustees may find themselves with a legal mess to untangle at a time when negotiating with the employer over how quickly the deficit can be paid off ought to be their top priority."
Ball added that - with impact of interest rate cuts and quantitative easing yet to be felt in full, and the VAT cut due to be reversed in January 2010 - pension schemes may have to contend first with a period of deflation and then with a period of prices rising quickly.
He said: "A few months ago, pension schemes were wondering whether inflation would go through the 5% barrier and lead to pension increases being capped. Next, they had to consider the possibility that inflation would go negative and it is too early to rule that out. If this happens, it will increase the real value of some people's pensions at the expense of their former employers.
"Trustees and scheme sponsors could now find themselves in the odd position of planning both for deflation and for faster inflation. The fact that the authorities started printing money after a month when prices rose shows how much uncertainty there is about the medium-term outlook. These risks are difficult to hedge: if a scheme buys index-linked gilts to protect itself against rising inflation, it will lose money in a deflationary environment.
Schemes which bought in annuity contracts exactly matching their obligations to pensioners may be particularly appreciative of the two-way inflation protection this provides."
BACKGROUND
Once in payment, defined benefit pensions accrued after April 5, 1997 are increased either in line with a statutory default basis or in accordance with the scheme's own rules.
For schemes using the statutory default basis, it is inflation in the year to September that determines the scale of pension increases.
If inflation were negative in September 2009 - as HM Treasury and most independent forecasters predict it will be - statutory default basis pensions would stay flat in cash terms and therefore rise relative to prices.
If inflation were positive again in September 2010, Watson Wyatt said it expected statutory default basis pensions would be increased with no offset for the previous year's deflation, though increases are capped if inflation rises above 5% (or 2.5% in the case of some benefits accrued from 2005). Similar arrangements apply to guaranteed minimum pensions accrued between 1988 and 1997, but with a 3 per cent cap.
For other, non-statutory default basis, schemes, the month used to increase benefits accrued after 1997 will depend on the scheme rules.
These rules may also signal whether trustees are permitted, or even required, to reduce pensions if inflation turns negative. The answer to this question could be different between post-1997 benefits and pre-1997 benefits that are not GMPs.
Even where scheme rules say that some of the pensions can be reduced, this could lead to penal tax charges which make reductions look unlikely in practice. Alternatively, some scheme rules may either permit or require trustees to use one year's deflation to offset any inflationary increase due the following year. If this rule applies only to the pre-1997 benefits, some pensioners will have part of their benefit increased in line with the statutory default and part of their benefit increased by a lower amount in line with scheme rules.
It warned in some cases a period of negative 12-month retail price index inflation could permanently increase the real value of some defined benefit pensions.
But it said that it could be possible that one year's deflation could be used to offset pension increases in the following year if a modest level of inflation returns.
With the impact of interest rate cuts and quantitative easing yet to be felt in full, and the VAT cut due to be reversed in January 2010, pension schemes may have to contend first with a period of deflation and then with a period of prices rising quickly.
Watson Wyatt head of defined benefit pension consulting John Ball said: "Tax rules make it unlikely that pensions would actually be cut but there is still a question about whether one year's deflation can be used cancel to out the next year's pension increases.
"If the scheme rules say this should happen, cost-conscious employers might not volunteer to pay for increases that do not have to be given. Trustees may also ask whether awarding pension increases above those required by the rules is fair on younger members, particularly if the scheme has a big deficit."
He added: "When the rules were written, no one really expected inflation to go negative. Accordingly, trustees may find themselves with a legal mess to untangle at a time when negotiating with the employer over how quickly the deficit can be paid off ought to be their top priority."
Ball added that - with impact of interest rate cuts and quantitative easing yet to be felt in full, and the VAT cut due to be reversed in January 2010 - pension schemes may have to contend first with a period of deflation and then with a period of prices rising quickly.
He said: "A few months ago, pension schemes were wondering whether inflation would go through the 5% barrier and lead to pension increases being capped. Next, they had to consider the possibility that inflation would go negative and it is too early to rule that out. If this happens, it will increase the real value of some people's pensions at the expense of their former employers.
"Trustees and scheme sponsors could now find themselves in the odd position of planning both for deflation and for faster inflation. The fact that the authorities started printing money after a month when prices rose shows how much uncertainty there is about the medium-term outlook. These risks are difficult to hedge: if a scheme buys index-linked gilts to protect itself against rising inflation, it will lose money in a deflationary environment.
Schemes which bought in annuity contracts exactly matching their obligations to pensioners may be particularly appreciative of the two-way inflation protection this provides."
BACKGROUND
Once in payment, defined benefit pensions accrued after April 5, 1997 are increased either in line with a statutory default basis or in accordance with the scheme's own rules.
For schemes using the statutory default basis, it is inflation in the year to September that determines the scale of pension increases.
If inflation were negative in September 2009 - as HM Treasury and most independent forecasters predict it will be - statutory default basis pensions would stay flat in cash terms and therefore rise relative to prices.
If inflation were positive again in September 2010, Watson Wyatt said it expected statutory default basis pensions would be increased with no offset for the previous year's deflation, though increases are capped if inflation rises above 5% (or 2.5% in the case of some benefits accrued from 2005). Similar arrangements apply to guaranteed minimum pensions accrued between 1988 and 1997, but with a 3 per cent cap.
For other, non-statutory default basis, schemes, the month used to increase benefits accrued after 1997 will depend on the scheme rules.
These rules may also signal whether trustees are permitted, or even required, to reduce pensions if inflation turns negative. The answer to this question could be different between post-1997 benefits and pre-1997 benefits that are not GMPs.
Even where scheme rules say that some of the pensions can be reduced, this could lead to penal tax charges which make reductions look unlikely in practice. Alternatively, some scheme rules may either permit or require trustees to use one year's deflation to offset any inflationary increase due the following year. If this rule applies only to the pre-1997 benefits, some pensioners will have part of their benefit increased in line with the statutory default and part of their benefit increased by a lower amount in line with scheme rules.
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