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."
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.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
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).
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).