Impact on pensioners
The rise in the cost of living will hit those on low incomes the hardest, including pensioners who generally rely on smaller retirement incomes for their way of life.
With wages far from keeping pace with inflation, retired members of a Defined Benefit (DB) pension scheme with pensions linked to inflation2 may have more chance of maintaining their lifestyle whilst the cost of living rises dramatically. A typical DB pensioner with inflation linked increases may see their annual pension rise from £8,500 to £8,920 (a £420 increase), whereas the average annual increase they would have seen over the previous two years would have been in the region of £150.
However, with energy prices rising and expected to rise further in 2022, this increase in pension may not be enough to cover the increase in energy costs for many pensioners.
Impact on UK DB schemes
The most important aspect for pension schemes is not the reported annual level of inflation, but the long-term expectations for future inflation. These levels have been rising as well, leading to increasing forecasts for member benefits and the corresponding liabilities. XPS’s DB:UK Funding Tracker estimates that rising inflation and falling gilt yields added around £100bn to liabilities of UK pension schemes over the second half of 2021.
The impact on individual schemes will vary considerably across the market as well-hedged schemes will be largely protected, while schemes with limited inflation protection will experience significant falls in funding levels. With many pension schemes in an improved situation from recent strong growth market performance, it may be a sensible time to review the levels of inflation hedging in place.
Despite continued rise in reported short-term inflation, long-term expectations of inflation have actually fallen over the last couple of months from a peak in October. Therefore, the impact of the latest reported year on year inflation levels on pension schemes is relatively modest.
What about Defined Contribution (DC) savers?
Although DC savers may be concerned at the erosion of the value of their savings, the rises in CPI follow continued strong growth market performance, driving up the value of their retirement pots. For the time being, growth markets continue to provide benefits for members in real terms. DC pensioners, and those in low-volatility investments approaching retirement, may have taken a hit from rising costs of living.
In the past we have seen many members of DC schemes take high, fixed pensions at retirement to maximise their initial benefits. Rising costs affecting pensioners, particularly energy and heating costs, are a timely reminder that all members should be aware of the impact of their choices at their retirement. Trustees should review their communications at retirement to ensure their members think about how they achieve a sustainable income in retirement.
Will this surge in inflation continue?
In the short term this seems likely, with some analysts now expecting inflation to reach a peak of 7% during 20223. Even if we witness relatively rapid stabilisation of prices or even falls from here, not that these are necessarily expected, the steady increase in prices that we have seen over the last 12 months means we can expect to see high levels of reported annual inflation for some months to come.
Simeon Willis, Chief Investment Officer, XPS Pensions Group, commented: “We are seeing reported year on year inflation continue to rise as each month passes and expect that to continue given the way annual inflation is calculated. Inflationary pressures remain both in terms of supply side constraints combined with plenty of consumer demand. December last year was not an abnormally low level for prices and in fact prices had never been higher prior to that point. This means even if month on month inflation reduces from here we wouldn’t see a big reduction in the reported annual level as there is a lot of inflation over the last 12 months that will still come through for some time to come.”
Tom Birkin, Actuarial Consultant, XPS Pensions Group, commented: “The impact of record inflation will be felt right across the pensions industry. While savers with inflation-linked defined benefit pensions will see an average bump in their annual entitlement of £420, pensioners on lower incomes will continue to be squeezed by the rising cost of living. The increase in inflation-linked entitlements will likely not be enough to offset rising energy bills, for example, so retirees may still end up worse off.
“Savers with defined contribution pensions have so far been insulated from their savings being eroded as a result of inflation by the recent stellar performance of financial markets. Savers with higher exposure to growth markets will have ended up better off, meaning that those closer to retirement – where investment risk is often tapered off – may be suffering the impacts of inflation more keenly than younger savers.”
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