The cost of living crisis continues to affect us all, dominating UK politics and the media. Less well reported is the extensive thought that trustees and scheme actuaries are currently giving to the high levels of short-term inflation.
Many trustee boards are considering benefit enhancements by making an advance allowance for the next inflationary increase in transfer values and early retirement calculations. Whilst there are clear reasons for increasing member benefits, careful thought needs to be given to ensure that any short-term adjustments do not have unintended consequences, or lead to disproportionate risks or additional costs.
For this reason, pension scheme sponsors must be aware of what is happening and should be actively involved in discussions.
What is the problem?
Most DB pensions increase with inflation. Increases are commonly based on the annual rate of inflation for September, which is published in mid-October and applied for retirements from the following January. This causes a step-change in benefits for those retiring shortly before or after the end of the year.
In an environment where inflation is stable, this does not have a material bearing on benefits. However, we are most certainly not in that environment. Many market commentators expect CPI inflation to be around 9% at September 2022 (with RPI inflation to be 11%) but for inflation to return closer to 3% to 4% over the longer term. Many member option terms (in particular those for early retirement) will have been set in a lower inflationary environment, which means that the step-change in benefits from 2022 to 2023 will be much larger than usual. For this reason, many trustees are considering providing higher benefits for calculations in 2022, in anticipation of higher future inflation.
Trustees will be working through several issues, including their funding and investment strategies, transfer values, and the unequal impact across pension scheme members. These topics each deserve a full blog of their own, but here I’ll focus on the impact on early retirements in defined benefit schemes.
Should early retirements in 2022 be enhanced?
When members retire early, their benefits are generally reduced to reflect the fact that they are paid for a longer period. The key principle is that the actuarial value of the normal retirement pension which would otherwise be paid is preserved and reshaped into an early retirement pension.
The current inflationary environment can affect those wishing to early retire in 2022, as many early retirement calculations will not capture the September 2022 increase before it’s formally released. This means that some members may be significantly better off if they defer their retirement until 2023 when that increase will be included in the calculations.
There is an emerging practice across the industry of allowing for the next inflation increase in advance, either through changing the approach to setting early retirement factors or applying a one-off adjustment.
At first sight, it seems difficult to argue against doing this. Why wouldn’t you compensate members for what seems to be the inevitable impact of high inflation? Well, things aren’t perhaps as simple as they seem. For example:
- Are trustees proposing an adjustment for inflation changes only, without considering wider changes to markets (such as increased yields) which may offset some or all of the impact?
- Has the additional administrative complexity and risk been considered?
- Is there time to adjust long-standing calculation proformas and processes at short notice, and who is bearing the cost?
- Are we setting a precedent? Is this a process which will need to be replicated in other years, and would the same approach be taken if a consistent approach resulted in a reduction in member benefits?
- Is this fair to all members? Do we need to top up past retirements, and if so, how far back do we go?
- Do existing member communications need to be updated for a short time only? How easy is it to explain this to members?
- This has a funding cost that affects all members – is this fair?
This is a long list – which isn’t exhaustive – but it serves to show the complexities involved. Different considerations will apply across schemes, and there is no one right answer. However, it is important that any adjustments are equitable and not simply the most generous approach.
Where to go from here?
Firstly, sponsors must understand changes that trustees are making to scheme factors. Although we would hope that the sponsor is consulted, as they ultimately underwrite the cost, this doesn’t always happen in practice.
Secondly, there must be a reasoned discussion before any changes are made. Ultimately, trustees and sponsors may jointly decide to enhance member benefits. However, this decision must be taken with full sight of the considerations above.
A key part of this discussion should be alternatives, for example maintaining the current approach – but informing members that they could be better off if they defer their early retirement. This has the benefit of maintaining the current structure, being low-cost, and helping members understand the impact that their retirement date can have.
Whatever the solution, it is essential that sponsors are involved in the discussions, as any adjustments for high inflation must be considered as part of an overall package for members that considers the interests of all stakeholders fairly.