Interest rates

The Effect of Rising Inflation and Interest Rates on Pension Plans | Denton

The UK is currently experiencing a spike in inflation, with record wage cuts and skyrocketing prices of goods and services, leading to a hard-felt ‘cost of living’ crisis. But what is the impact for UK occupational pension schemes?

The Consumer Price Index (CPI) measured inflation at 9.1% at the end of May 2022, the highest level seen since February 1982. Governments have traditionally sought to counter rising inflation by raising interest rates, to encourage people to spend less and save more, as seen recently in the Bank of England’s decision to raise the base rate from 0.1% to 1.25% . With inflation expected to continue to rise this year, below-inflation pension increases should become the norm, but is this consistent with the fiduciary duties of fiduciaries? At the very least, the impact on diets will probably have to be taken into account. We explore the impact of high inflation and high interest rates on pension plans in more detail below.

What is the effect of rising inflation on defined contribution plans?

The ultimate effect of higher inflation is that in real terms, the defined benefit plan (DB scheme) members are likely to be worse off. Over the past 30 years, members of DB plans have been largely protected against increases in inflation, as private sector DB plans have often increased and re-evaluated benefits in line with inflation. However, these increases have always been capped and fall well below the runaway rate of inflation, which now erodes this protection. As a result, DB Scheme Trustees may wish to review the impact on their members and communicate as necessary to make members aware of this issue and any proposed action to address it.

DB Scheme sponsors should also consider which index is used to gauge inflation. Many DB schemes have started using the retail price index (RPI), an index which the Office for National Statistics encouraged to abandon, but switched to the CPI where the RPI was not hard-coded into the rules of the scheme. The CPI is generally a lower rate and the difference between the indices is currently around 2%.

As inflation rises, DB plan trustees and their sponsoring employers may come under pressure from members to grant discretionary increases beyond those provided by plan rules. Such increases are unlikely to be required by DB plan rules but, when a plan is operating in surplus, it can be difficult for sponsoring employers to at least refuse to consider the application. Of course, any request for a discretionary increase in deficit-operated DB plans will be much less likely to succeed.

When setting early retirement factors, the legislation requires that trustees be “reasonably satisfied” that the total value of an early retirement benefit is at least equal to the total value of the member’s normal retirement benefit. This is generally considered across the whole scheme and updated from time to time based on changing market conditions. Conditions here in the UK have now changed enough that trustees will likely need to consider adjusting early retirement factors ahead of normal review dates, to ensure they remain ‘reasonably satisfied’ it is the case.

The Current Funding of DB Plans

However, the situation is not entirely bleak. Deficits are down overall in the current economic environment. XPS Pensions Group’s DB:UK funding tracker reports that the UK DB Scheme’s shortfalls against long-term funding targets fell by around £56bn during the month of June. As DB plan deficits decline overall, despite the challenges faced by a difficult economic climate, there may be a lag before we see the full impact of rising interest rates and inflation. Sponsoring employers may well still be slow to consider granting discretionary increases and may reasonably decide to take a longer-term and more cautious outlook.

The effect on defined contribution plans

Defined contribution plans (DC plans) are not immune to the effect of rising inflation. Members of DC plans may see the value of their retirement pot (and therefore their purchasing power for retirement annuities) decline as they approach retirement. Members who contribute a fixed percentage of salary can be protected against the dangers of high inflation, where that salary increases with inflation. In practice, this is unlikely to be the case for many workers, especially those in the public sector. Therefore, sponsoring employers and trustees of DC plans may consider researching and providing advice to members regarding default investment strategies and other potential investment options to try to mitigate this. Individual members should also consider obtaining independent financial advice when considering changes to their investment options or before seeking access to benefits.

Potential Solutions

Various methods can be used by plans and trustees as a potential solution to rising inflation and interest rates, such as risk reduction.

One of these methods consists of incentive exercises. This usually involves either:

  • an Enhanced Transfer Value (ETV) exercise, where members are offered an increase in their benefits, in exchange for transferring cash for their DB pension to another (usually defined contribution) pension scheme; Where
  • a Pension Increase Exchange (PIE) exercise, where members forego certain non-statutory future increases to their benefits, in exchange for a higher initial pension.

Certainly most, if not all, plans should undertake a member communication exercise to highlight member options. This would simply involve writing to members outlining the benefit options available to them under the scheme and advising members to consider those options well before retirement – in practice members are much more likely to choose the one of the options available after a call. exercise. This can often be useful for small plans that are nearing redemption.

Buyouts are another risk reduction option, increasingly used as a way to reduce funding risk. This essentially involves trustees obtaining benefits under an insurance policy that covers a specified proportion of a plan’s liabilities. A premium is paid to an insurer in return for guaranteeing this proportion of the scheme’s liabilities. This can be used to reduce the risk of plan liabilities in times of uncertainty. However, trustees should carefully consider the specific plan liabilities they wish to cover, in order for this to be an effective risk reduction practice.

Conclusion

While adopting a “wait and see” approach may prove effective for some trustees, with the Bank of England predicting that inflation will continue to rise, trustees and sponsoring employers of DB and DC schemes should prepare and consider the impact on their diet. . Member communication exercises and early retirement factor reviews will be essential tools to address, at least partially, the impact of the current economic climate on pension plans.