Cost of discretionary increases to combat inflation could hit £18bn

Inflation, as measured by the consumer price index, hit 9.1 per cent on June 22, up from 7 per cent in April, and is expected to rise yet further, adding to an already burdensome cost of living crisis.

Quilter Investors portfolio manager Paul Craig said the rate of growth in inflation “may have slowed” but that this is likely “not the peak”, with the Bank of England forecasting it could climb to 11 per cent later in the year.

“Disappointingly, the cost-of-living crisis is not going to be a short-lived affair, and this ultimately leaves the Bank of England stuck between a rock and a hard place,” Craig said.

The ability to award discretionary increases is very much a postcode lottery for trustees of occupational DB schemes and their members

Emma King, Eversheds Sutherland

While a large number of pension schemes have been hedging inflation for some time — rising by 24 per cent to £24bn back in February — the high inflation rate will have a bearing on those schemes where the rules allow for the awarding of discretionary increases above the cap, which is typically set at around 5 per cent.

In May, Aon estimated that the cost to liabilities of schemes awarding discretionary increases could be around £8bn. 

But that figure has now surged to £18bn, according to Aon partner Lynda Whitney, who told Pensions Expert: “If we look at the impact of inflation on a DB or [defined contribution] pension with no increases when inflation is running at 2.5 per cent a year, then the buying power of a pension with no increases will halve in 28 years.  

“With inflation at 5 per cent a year it will halve in 14 years; at 7.5 per cent a year it would halve in just nine years.”

Though DB scheme trustees may wish to consider affording increases where the rules allow for it, she added that there were a number of considerations besides the impact on members, and that the difference in how members fare between DB and DC should also be borne in mind.

“You also need to consider this is a benefit improvement and that might be hard for employers to stomach after so many years of paying deficit contributions,” she explained.

“Sponsors might also be thinking about what salary increases they can afford to pay ongoing staff before thinking about pensioners,” while for schemes themselves, most are still “significantly short” of their long-term targets, and discretionary increases “could increase the time to reach those targets, thus reducing security for members”.

Discretionary increases are 'a postcode lottery'

Legal experts stressed the need for trustees to check the rules of their schemes to establish whether, and when, they are able to award discretionary increases, should that be their preferred route forward.

Eversheds Sutherland partner Emma King told Pensions Expert: “The ability to award discretionary increases is very much a postcode lottery for trustees of occupational DB schemes and their members. The existence of a discretionary increase will depend on the wording of the rules of the scheme and will vary from scheme to scheme.  

“Many of our clients are actively looking into what they can do to provide protection for their pensioner members with inflation on the rise.

"As inflation on this scale has not been seen for some four decades there are some historical rules that are being dusted off. This includes what factors scheme trustees need to think about when determining whether to exercise a discretionary power to award increases above the statutory minimum.”

Arc Pensions Law senior partner Anna Rogers explained that while most schemes give fully guaranteed increases on a whole pension, subject to caps and floors, some pension funds do not extend that to pre-1997 accruals; and these schemes, where pre-97 increases are discretionary, “know they have an issue [that] may become more pressing this year”.

"Trustees should check their powers. Can they decide on increases or do they need sponsor consent? Does the funding level allow an increase without an additional contribution? These issues will be familiar,” she explained.  

“What sometimes gets overlooked though is that there are schemes that have a legacy power or even an obligation to consider discretionary pension increases. This has gone by the board in recent years because inflation has been so low. I saw one recently where the obligation was on the sponsor to consider the issue, every year."

She added that there “might not be much hope” of an increase being awarded “unless there is a big surplus”, but stressed that members would be within their rights to complain if there is an obligation “that has been ignored”.

“As a matter of good governance, schemes should be checking what the rules say. They should also be aware that there may be more than one pension increase rule applying to the current population — often three or more.

"A high-inflation environment is hard on pensioners, but if trustees can’t afford to do anything about it they should at least make sure they don’t leave themselves unnecessarily exposed to criticism."

Trustee concerns

Besides checking whether their scheme rules allow for discretionary increases in the first place, trustees will have to consider a number of factors when deciding whether to afford them.

Taylor Wessing senior associate Georgina Wardrop told Pensions Expert that different scheme rules place the decision-making power as regards discretionary increases with different people, whether that be the employer, a combination of employer and trustees, or, “less commonly”, trustees alone.

“Given the significant increases in inflation, trustees and employers that have the power to award discretionary increases should consider whether it is appropriate to do so, or to change the level of any discretionary increases already being paid. Such discretionary increases would generally be funded from scheme assets,” she explained.

Some schemes may not allow for discretionary increases but will nevertheless have augmentation powers, she continued, which allow benefits to be increased without a rule amendment being required.

“Schemes may wish to consider whether to use this route to increase the rate of pension increases. Such augmentation powers are generally exercised by the trustees with the consent of the principal employer, with a requirement that the employer(s) must agree to any additional funding that the scheme actuary considers necessary in order for the augmentation to be made.”

She added that, where the employer’s agreement is required to any augmentation or discretionary increase, the employer is obliged to “act in good faith”, but is “entitled to take account of its own interests" when making a decision, which "generally means that there is no obligation on the employer to agree”.

For trustees who are party to the decision, she noted they are required to “take account of all relevant factors”, which include the funding position of the scheme, any significant costs, expenses or funding risks anticipated in the future, the impact of inflation on different categories of member (and the increases they are already entitled to), any contractual agreements with members outside the scheme’s governing documents, and the cost of providing the increase or augmentation.

King added: “Trustees are responding quickly to inflation by considering their options. But it is also worth pointing out that many schemes are finding that they have hedged well against inflation and are ahead of their funding targets.

"For those schemes that are in a well-funded position, the ability to award a discretionary increase would allow trustees to help protect their pensioner members from the effects of inflation.”