The government policy devaluing your pension

The government's announcement that it intends to use the consumer prices index (CPI) to calculate pension increases rather than the retail prices index (RPI) could see millions of people receiving lower incomes in retirement. 

Its intention, designed to reduce the cost of funding final salary schemes, was first revealed in the emergency Budget in June.

Chancellor George Osborne announced that, from next April, increases in public sector pensions would be linked to CPI. Two weeks later, pensions minister Steve Webb announced that this would also be extended to private sector pensions.

"Using the CPI rather than RPI will affect pension income. Although the difference between the two indices fluctuates, in the long run CPI is around 0.5 percentage points lower," said Mike Smedley, pensions partner at KPMG.

Treasury forecasts for the two indices highlight the level of reduction members will see.

Assuming a weekly pension income of £200 in 2010, and taking the previous year's index figure, by 2015 a CPI-linked pension would increase to £221.90. If, however, the RPI link had been maintained it would be worth £234.57.

In addition to affecting those already receiving a pension, this change will also hit people who have left a final salary pension scheme but haven't yet retired. In these cases, the benefits are uprated each year.

"Depending on your age when you left the scheme, this could potentially reduce your income by thousands of pounds," explained Laith Khalaf, pensions analyst at Hargreaves Lansdown. "If you left a scheme at age 40, that could be 25 years of lower increases to your pension pot."

Impact on public and private schemes

However, while all public sector pension scheme members will be affected by the change, it's unlikely that it will affect all private sector scheme members.

"It all depends what's in the pension rules. Public sector pensions refer to the government order so they can move to a CPI link without a problem, but in the private sector some schemes have RPI links written into the rules.

Unless the government brings in legislation to override this, it will be difficult for these schemes to move to a CPI link," said Andrew Bradshaw, partner at Sacker & Partners.

Where it's possible to move to the CPI link it will certainly be in employers' interests to do so as it could considerably reduce the cost of funding the scheme.

According to Anthony Barker, managing director of Pension Capital Strategies, schemes could see their liabilities reduced by between 9% and 10%, with associated costs such as the pension protection fund levy also falling.

But research from KPMG shows that many schemes won't be able to switch so easily to the new link.

It found that although 80% of schemes would be able to change the rules for people who had left the company and had deferred pensions, only 20% of schemes could change the link for people who had already retired.

For these schemes, even if the government were to step in, Bradshaw believes it would still be difficult to extend the CPI link to people already receiving pension benefit: "If someone's been told they have a pension that increases in line with RPI, then you can't take this away from them. If the government pushes this through it could find itself in trouble with the EU."

Another point to bear in mind is that, although CPI is generally lower than RPI, this isn't always the case. The difference between the two is that while RPI includes housing costs such as mortgage interest and council tax in its basket of goods, these are excluded from CPI.

"CPI does better reflect the expenditure that pensioners have and is a much more stable measure of inflation. It can also be higher than RPI, as was the case in 2009," said Brian Peters, pensions partner at PricewaterhouseCoopers. 

The rules regarding how the change will affect private sector pensions are yet to be finalised, making it difficult for members of these schemes to understand how to amend their pension planning.

Khalaf added: "If you haven't yet retired and your scheme is affected, you might want to consider using a personal pension to boost your retirement income.

"If you've already retired, it will be tougher, but you could save any surplus income you have now into an ISA for future years when the growth in your income will be more meagre."