Defined benefit pension schemes in the UK could face an extra GBP5 billion of funding pressure if the level of inflation turns negative in coming months, according to an analysis by pension consultancy LCP.
Defined benefit pension schemes in the UK could face an extra GBP5 billion of funding pressure if the level of inflation turns negative in coming months, according to an analysis by pension consultancy LCP.
Negative inflation presents a problem for pension schemes since most cannot reduce existing pension payments, even if inflation is negative, and the value of those pension payments goes up relative to the rest of the economy.
In April, the UK inflation rate had already tumbled to 0.8 per cent, over one per cent off the Bank of England’s two per cent inflation target. A further fall is expected when May’s figures are published at the end of this week.
LCP modelled the likely level of inflation over the coming months, based on three scenarios – representing a slow, medium, or speedy economic recovery.
The firm says that a ‘medium’ speed economic recovery would see September’s CPI inflation hit -0.5 per cent, with RPI inflation dropping to -0.8 per cent.
With around GBP800 billion in index-linked DB benefits in payment in occupational pension schemes, a 0.8 per cent increase in the real cost of benefits could represent a GBP5 billion hit on schemes and their sponsoring employers.
Under a ‘slow’ recovery, the firm warns that CPI inflation could fall to -2.8 per cent in September. September is an important month for measuring inflation for pension schemes, says LCP, since it can affect how far pensions are uprated. State pensions are set to increase by a minimum of 2.5 per cent, thanks to the triple lock.
LCP warns that this could lead to a “ratchet effect”, where pensions are expected to increase by more than inflation, raising costs in the medium term above the level that schemes have budgeted for.
If the level of inflation later turned positive again, pensions’ value will have increased more than they would with a steady rate of inflation.
“Ultra-low interest rates and market volatility has already weakened the funding position of many schemes, but negative inflation could add a further financial burden. Schemes generally cannot reduce pensions in payment even when prices are falling, resulting in a real-terms increase in the cost of providing pensions,” says Jonathan Camfield, partner at LCP.
“We anticipate that this could add at least GBP5 billion to long term scheme costs and the burden on their sponsoring employers as deflation is expected to be experienced in the economy over the coming months.”
Industry body the Pensions and Lifetime Savings Association (PLSA), echoes the consultancy’s concerns. Tiffany Tsang, senior policy lead for defined benefit pension, says: “The impact of low or negative inflation will be coming during a much more complicated and potentially challenging period for employers and schemes than could have been envisaged.
Tsang says that on top of the risk of negative inflation, the pensions industry will be adjusting to new regulation. “In addition to what LCP has highlighted, tPR’s new DB Funding Code and Government’s suggestions to align RPI to CPIH will have implications as well. As such, tPR’s recent easements could continue to remain crucial for the survival of schemes and employers.”
The Pensions Regulator has set out planned changes to the defined benefit (DB) funding code, to better manage risks on long-term scheme funding and investment strategy planning.
“The new DB Funding Code will ask schemes, among many other things, to concentrate on long-term strategies – and whether to run on, potentially consolidate with a superfund or buy-out – plans that may need re-evaluating after the events of the last few months,” says Tsang.
The revised code of practice is expected to come into force at the end of 2021 after a second consultation at the end of 2020.
Tseng highlights recent estimates from KPMG that this new funding code “could add an additional GBP100 billion to UK pension deficits” – as an aggregate increase across all UK schemes, with the average pension scheme seeing its deficit rise by 50 per cent – and “could result in the doubling of pension contributions for a typical employer”.
“This figure will undoubtedly have swelled in recent weeks given the shock on global markets in March 2020 from the outbreak of Covid-19.”
Tsang says that long-term challenges for pension funds could be further compounded if the government decides to go ahead plans to align the retail price index, with the consumer price index, as a better measure of inflation.
“The Pensions Policy Institute estimates that for pension schemes that use RPI-linked gilts, for every GBP10 million invested, they would see a loss of GBP1 million in asset value if the changes are made in 2030; this figure doubles if the change is made in 2025.
“A significant fall in the income received from RPI-linked gilts would lead to a reduction in scheme funding. This funding gap would require higher contributions from employers, which may be difficult to achieve under the current economic climate.”
