Rising Inflation to Blow £7,000 Hole in Pensions

Millions of final-salary pensioners face a £7,000 hit because of a failure to proof their benefits against inflation.

Britons who worked in the private sector are set to suffer because of a cap on increases that means they will not keep pace with price rises.

The flaw will cost the pensioners an average of £400 this year and £7,000 over their lifetimes while potentially saving businesses that sponsor the schemes about £30 billion. Almost all defined benefit (DB) schemes, which pay out a set amount each year depending on length of service, lifted benefits by a maximum of 5 per cent per year, even when inflation was higher. The cap was cut to 2.5 per cent in 2005. Before 1997, there was no requirement to index payments at all.

With inflation forecast to hit 9 to 10 per cent later this year, as measured by the consumer price index, almost all members of DB schemes in the private sector will see their benefits permanently reduced in real terms. More than five million retired civil servants and other public sector workers in DB schemes will be unaffected because there is no cap on their schemes. Their pensions will be raised by the full inflation rate, however high.

The change is likely to shock many people because inflation has rarely approached the 5 per cent cap over the past 30 years. The issue affects the 4.2 million former private-sector employees drawing a pension from one of more than 5,000 traditional DB schemes. They will not claw back the lost income in future years because of the ratchet effect of the caps.

Steve Leake, an actuary with XPS Pensions, said: “If inflation were to reach 10 per cent, this would mean that UK pensioners would be missing out on £1.7 billion per annum of pension in real terms, equivalent to £400 a year for the typical DB pensioner. On the other hand, the cap means UK DB schemes are protected from an additional £30 billion of liabilities.” Leake said he expected some DB schemes to come under pressure from members to award discretionary increases in excess of the rules. Such awards were common in the 1980s when inflation was high and some funds had large surpluses.

“It is going to become a real debate for trustees, especially as we start to see stories about pensioner poverty,” Leake said.

The impact of inflation will vary enormously on individual members depending on when they accrued their pension and the terms of the individual scheme. The state pension also faces a real-terms hit: it rose by 3.1 per cent last month just as prices were forecast to go up by three times as much.

John Ralfe, an independent consultant, said it was “hugely complicated,” but the “vast majority of private sector DB pension members already drawing their pension were going to see a significant cut to their real incomes — and it will last for the rest of their lives. They won’t claw back the lost income even when inflation falls back again.”

Pensioners in more modern defined contribution (DC) schemes, which pay out based on contributions made by the employee and employer, are likely to be even worse hit. Those who have taken an annuity typically opt for a flat rate that gives a higher income at first but no inflation protection.

The 4.6 million people who are not yet retired but are due benefits from a private sector DB scheme, known as deferred members, are less likely to be hit by a short-run increase in inflation because of the different way their benefits are indexed.

Age UK has warned that pensioners are facing a crisis this autumn, when energy bills are set to rise again. Caroline Abrahams, its director, says: “Older people are telling us they are horrified by letters from energy companies, making clear bills are set to rise beyond anything they’ve seen before.”

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Rising inflation to blow £7,000 hole in pensions