Private pensions to suffer alongside public sector cuts
The government is planning to change how private sector pensions are calculated so that all pension members will ‘share the pain’ of reduced payments in retirement.
From next year, final salary pensions will be increased in line with the consumer prices index (CPI) rather than the retail prices index (RPI). It was previously thought that this would only cover public sector and state pensions, but it will now also extend to the private sector.
Such a move will likely make pensions less generous as the CPI – which does not include housing costs unlike RPI – is typically lower than the RPI. Over the past 20 years it has been higher than the RPI only three times.
Dr Stephen Barber, adviser on economics and markets at brokers Selftrade, comments: "Occupational pensions will see a significant drop in valuations as a result of this link to CPI rather than the usually higher RPI.
"In part this move is of course political. Consistent with state and public sector pensions, it shows we are all sharing the pain."
The planned move will mean changes to the amount final salary scheme members receive each year in retirement. It will also affect people’s pensions when they move jobs.
When you leave a final salary scheme you are entitled to a preserved pension. Until now the government has required that these preserved pensions are revalued in line with RPI each year until retirement, but this will change to CPI.
The proposals mean up to 12 million final salary scheme members face a cut in their pension.
TUC general secretary Brendan Barber calls the inflation announcement by pensions minister Steve Webb "a stealth cut on the pensions of middle income Britain".
He says that while the coalition "undoubtedly deserves praise for their early commitment to linking the state pension to the higher of earnings or prices, it now looks as if most other pensions will go up less than they used to in most years".
However, for some companies it will be music to their ears. Firms like British Airways, Royal Mail and BT have enormous deficits in their final salary pension schemes and by changing the inflation measure it will mean the liabilities are reduced.
Barber says savers and investors should review their portfolios to help them better prepare for retirement. He also believes there may be opportunities for investors as some of the big pension companies may see a "welcome boost to returns" following the announcement.
Replaced as the official measure of inflation by the consumer prices index (CPI) in December 2003. Both the Retail Price Index and CPI are attempts to estimate inflation in the UK, but they come up with different values because there are slight differences in what goods and services they cover, and how they are calculated. Unlike the CPI, the RPI includes a measure of housing costs, such as mortgage interest payments, council tax, house depreciation and buildings insurance, so changes in the interest rates affect the RPI. If interest rates are cut, it will reduce mortgage interest payments, so the RPI will fall but not the CPI. The RPI is sometimes referred to as the “headline” rate of inflation and the CPI as the “underlying” rate.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
Final salary pension
A defined benefit pension scheme is one where the payout is based on contributions made and the length of service of the employee. A typical scheme would offer to pay one-60th (0.0168%) of final salary (the one you’re earning when you finally retire) for each year of contributions to the scheme (even though these years were probably paid at a lower salary). Someone retiring on a final salary of £30,000 who had been a member of the scheme for 25 years would receive a pension of 42% of their final salary (£12,300 a year before tax). Sadly, many companies are winding up their final salary schemes or closing them altogether, meaning pension benefits accrued after a certain date (or those available to new employees) may be on a less generous money purchase basis.
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).