Inflation will have wide ranging impact on schemes

High inflation could be positive news for schemes with caps in place

Jonathan Stapleton
clock • 4 min read
LCP partner Jonathan Camfield
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LCP partner Jonathan Camfield

The consequences of inflation for defined benefit (DB) funding will be wide ranging depending on individual pension scheme circumstances, Lane Clark & Peacock (LCP) says.

This morning, the Office for National Statistics announced its September inflation figures of 10.1% for the Consumer Prices Index (CPI).

The September numbers are particularly important as they form the basis for many pension schemes' annual benefit increases which will be applied in April 2023.

But LCP partner Jonathan Camfield said the consequences of inflation for DB pension scheme funding could be wide ranging depending on their individual circumstances.

As an example, he said that as legislation provides a cap on the amount of inflation protection which schemes are legally required to provide to member benefits - even when inflation reaches double digits - scheme liabilities may rise much less than this, meaning the net effect could be positive for scheme funding.

On the other hand, he warned benefits of statutory caps on minimum inflation protection could be less for schemes where scheme rules provide for more generous inflation protection - noting an uncapped inflation increase would be substantially higher than a 5% cap.

He said the impact of inflation on scheme funding would also depend substantially on the extent to which schemes have ‘hedged' their exposure to inflation.

Camfield explained: "When it comes to DB scheme funding, the impact of inflation will vary hugely from scheme to scheme.  But perhaps counterintuitively it's not always bad news. 

"For some schemes, and particularly those with limited and capped exposure to indexation, high inflation can actually be good news, especially if the assets side of the equation is boosted when prices rise.  The more challenging impact comes for schemes with uncapped inflation increases, particularly if those schemes are not fully inflation protected in their assets."

Hymans Robertson senior investment consultant Ben Farmer agreed: "Most private sector defined benefit schemes' annual increases for pensions in payment are capped, often at 3% or 5%. The index-linked gilts that many schemes hold as part of their risk management strategies have no such cap on their inflation linkage, so at the margins well-hedged schemes might expect to benefit from a funding perspective from high inflation.

"For less well-hedged schemes, this marginal gain from uncapped assets vs capped liabilities will likely be outweighed by the general increase in the liabilities from high inflation."

The impact on members

Farmer added that there was also a difference between how deferred and pensioner members would be treated - with deferred members typically having the annual cap applied cumulatively, meaning they are likely to benefit to the full extent of the currently high inflation.

Farmer said: "This morning's release will no doubt raise the question with pension scheme trustees, and sponsoring employers, of whether to award members discretionary increases to benefits.

"These conversations often haven't taken place since the 1990s, when the macroeconomic and pensions landscapes looked markedly different. The balance here is the desire to protect pensioner members in the current high inflation environment, versus the increase in pension scheme liabilities this would cause, at a time when many DB pension schemes are already in a funding deficit seeing funding challenges."

XPS Pensions Group agreed - noting some DB scheme members could lose £500 a year due to inflation caps.

The consultancy said most of the six million members who are yet to retire will receive a full inflationary boost to their pensions - but noted the 4.5 million members who have already retired will not, as any increase to their pension is likely to be capped.

XPS Pensions Group explained the level of these caps vary from scheme to scheme but are typically between 3% and 5% - meaning that the average defined benefit pensioner could be missing out on annual income of £500, equating to around £8,000 over a lifetime.

Senior consultant Charlotte Jones said: "Contrary to reports over the last couple of weeks, from a funding perspective most defined benefit pension schemes are doing well despite the market turmoil brought on by the mini budget. XPS's DB:UK funding tracker estimates that schemes currently have over £160bn of surplus funds following the sharp rise in gilt yields seen in the past few weeks.

"With schemes' funding improving during a cost-of-living crisis, pensioners of defined benefit schemes may ask whether those excess funds could be used to help them pay their bills this winter."

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