MT Expert - Finance: Inflation and pensions

What goes up doesn't always have to come down, says Watson Wyatt...

Last Updated: 31 Aug 2010

Figures released by the Office for National Statistics this week confirmed that the Retail Price Index fell by 1.4% in the year to September. September's RPI is signficant for pensions as both State Pensions and public-sector pensions are calculated with reference to September's inflation numbers. Many private sector schemes are also linked to RPI, though not always the year to September.

But neither pension will fall in response to the 1.4% fall in prices. Following the backlash against the 75p increase in the Basic State Pension back in April 2000, the government's policy has been that the Basic State Pension will always rise by at least 2.5% each year.

Last year, pensioners got a strong increase because September 2008 was a high-water mark for inflation. This time the opposite could have been true but, thanks to the 75p backlash, the Basic State Pension will still go up by £2.40 in April 2010.

Quite whether pensioners will see this as a good result is a different matter. Ironically, the measure of inflation used to up rate State Pensions ignores spending by the pensioners who most rely on them, and inflation is still positive if you focus on the things they buy.

By the time we get to April 2010, falling prices could also be a distant memory. Prices have increased by 2.5% in the last eight months and it's only because the headline figures look at changes over a full 12 months that inflation is negative. VAT going back up in the New Year will also exert upwards pressure on prices.

There are over two million pensioners receiving benefits from the four main unfunded pension schemes for the public sector - those for the NHS, the civil service, teachers and the armed forces. Pension increases in these schemes are also based on RPI inflation in the year to September but similarly pensions can only go up and cannot be reduced and will stay flat in cash terms. 

Not all private-sector pension schemes use September inflation data to determine increases, but RPI inflation has now been negative for seven months in succession, so many schemes using different reference dates will also have to grapple with the same issues. Their response to negative inflation will depend on scheme rules. As in the public sector, it is unlikely that benefits will be cut - partly because this could trigger tax penalties. However, some scheme rules may allow or even require one year's negative inflation to offset the inflation-linked increase that would otherwise be awarded the following year. 

Neither public-sector nor private-sector pensions will be cut when inflation is negative but there could be a difference when inflation returns. People in public-sector schemes should get a full increase when inflation is positive again but some people with final salary pensions from private-sector employers may not. If there is a big deficit, awarding pensioners increases that are not required by the rules could make younger members' benefits less secure.


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