Key points:
• The UK’s combined DB deficit could be reduced by £175bn if all schemes could switch from RPI to CPI for pension increases and revaluation – but this would reduce the benefits of an average DB scheme member by £20,000
• If schemes could reduce pension revaluation and increases further to the statutory minimum requirement, this could take a third off the £1 trillion UK DB deficit but cut the average scheme member’s benefits by £32,500
• When schemes enter the PPF, members benefits are reduced by £45,000 on average
Commenting, Jon Hatchett, Head of Corporate Consulting, said: “Deficits hitting a record £1 trillion, and high profile scheme failures such as BHS and Tata Steel, have pushed DB pensions up the political and corporate agenda. Deficits could be reduced by hundreds of billions if schemes could turn off, or reduce, annual increases to pensioner income linked to inflation. However, current rules prevent companies breaking promises made to pensioners.
“One area the Work and Pensions Select Committee will look at is whether benefits should be cut if a scheme is in distress. This could mean reducing pension increases from RPI to CPI, reducing to statutory increases, or more dramatically through a suspension of pension increases altogether.
“The first option would essentially see an end to the ‘scheme rules lottery’. Around three quarters of the UK’s 6,000 DB schemes link annual pension increases to RPI. Some schemes are bound by the wording in their rules to use RPI as the basis for pension increases, while others are free to use CPI. Switching to CPI would improve the affordability of schemes for sponsors by cutting members benefits, with an aggregate affordability improvement across UK DB of around £175bn.
“The challenge to this is that many schemes and sponsors are able to support their RPI based promises. Politically and morally it would be difficult to make a case for worsening future indexation, taking away £20,000 in benefits over an average DB scheme member’s life.
“A second, more dramatic, option would be to allow schemes to reduce pension revaluation and increases to the statutory minimum requirement. This would ride roughshod over schemes trust deed and rules, but provide an even bigger release of pressure. In aggregate this slashing of benefits would improve affordability by around £300 - £350bn, removing around one third of the total buy-out shortfall in the UK of £1tn.
“There is a final option which is yet more extreme. This would be to enable schemes in dire straits to stop paying pension increases for a limited time, until scheme funding and business performance recover. This is known as ‘conditional indexation’. Allowing struggling schemes to temporarily stop paying pension increases could help them get back on track while avoiding permanent cuts to members’ pensions. It could be a way to create the breathing space to allow businesses to turn themselves around rather than being pulled down by struggling pension schemes.
“This would be the ‘least worst’ option for members. The cutbacks only apply when full benefits are not affordable, and members at least retain the chance of getting their increases back if the scheme’s or sponsor’s position improves. For many that’s likely to be a better outcome than entering the PPF where they’d see an irreversible cut in value of £45,000 over the course of their retirement.
“Policies like conditional indexation come with a hefty risk warning and would need watertight safeguards. For example, the suspension of pension increases should be temporary and with strict restrictions on employers (such as dividend freezes and substantial pension contributions) to align business and scheme members interests. Another safeguard would be forcing schemes to reinstate lost increases before they could be wound up. These options should only be available to genuinely stressed schemes.”
Concluding, he said: “We need to remember that the majority of DB schemes will be able to pay benefits in full. Any changes to the regulatory regime should not penalise the large majority of well-run schemes to deal with the challenges faced by a minority at the edges. Given the flexibilities in the current integrated risk management funding regime, deficit funding should never become the straw that breaks the sponsor’s back. Nonetheless funding and investment strategies will be under more strain than ever before in the current low yield environment.”
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