Defined benefit schemes in the UK will have to weigh up the significant costs of granting discretionary increases later this year, which could add up to £8bn in liabilities across private sector DB schemes, according to Aon.
Consumer price index inflation hit 7 per cent in early April, while the retail price index recorded 9.9 per cent, and the Bank of England forecasts that CPI will increase to 8 per cent in spring and then rise again later in the year before falling “considerably” over the next two years.
Rising inflation prompted many institutional investors to turn to hedging, asreported in February, with interest rate hedging growing to £46.5bn, an increase of 27 per cent, while inflation hedging lifted by 24 per cent to £24bn.
Overall, trustees and sponsors will need to look at their complete long-term funding plan and understand how guaranteed and discretionary pension increases fit within it and make decisions accordingly
Lynda Whitney, Aon
While many schemes are well-hedged and have been for years, the Pensions Regulator still saw fit to include uncertainty around future price rises in its annual funding statement, as inflation can pose a number of problems for schemes. One such problem arises when DB schemes come to award pension increases.
Discretionary increases are expensive
A large number of schemes place caps on their increases of around 5 per cent a year. But with inflation topping 5 per cent when measured by both the RPI and the CPI — especially in September, which is a key reference month when determining pension increases — certain schemes will have to ask whether they can, and whether they should, award discretionary increases above the cap.
Aon explained that the last time RPI inflation topped 5 per cent was in 2011, but that schemes were typically in a different position at that time. It said that schemes’ technical provisions deficits are lower now than they were then, and in some cases there are now technical provisions surpluses.
Other differences exist, Aon continued. For example, many schemes are now heading for long-term funding targets but are some way short of them, and in these cases discretionary increases could lengthen the journey time, thus reducing member security.
Though schemes are now engaged in more inflation hedging than they were in 2011, in some cases assets will be increasing faster than liabilities because the hedge may not have accounted for the cap.
Additionally, inflation in 2011 only topped 5 per cent for a short while before falling, whereas now inflation is going much higher for a lot longer, with certain impacts — such as fuel prices — hitting pensioners particularly hard, Aon argued.
Were schemes to award discretionary increases, it could add up to £8bn to their liabilities.
Aon partner Lynda Whitney said: “A potentially tricky situation is looming and schemes need to be clear from a governance perspective on where the decision sits.
“Is the discretionary increase power with the trustees, the sponsor or a combination of the two? Even if either party has unilateral power, reaching a consensus will often be desirable.
“It’s possible that some schemes could justify that they have been receiving significant deficit contributions to meet the guaranteed benefits, and do not see the current scenario as a reason to provide a benefit improvement.”
Whitney added that it was “logical” for schemes “not to pay the benefit improvement of discretionary pension increases and to progress faster on the journey to their long-term target. But there could be much more public demand now for discretionary pension increases than there was in 2011.
“We are currently navigating new forms of volatility, and with a different economic landscape in 2022 there is much more public awareness of high inflation,” she said.
Members with elements of pension that receive no guaranteed increases, such as those with discretionary increases on pre-1997 benefits only, will feel the impacts of inflation more keenly, she continued.
“For example, with inflation at 2.5 per cent a year, the buying power of this type of pension 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. But this is a feature of the benefit design and does not necessarily imply that it is a pension scheme’s responsibility to help manage it.
“Overall, trustees and sponsors will need to look at their complete long-term funding plan and understand how guaranteed and discretionary pension increases fit within it and make decisions accordingly. But they may also need to be ready to explain to members how they have reached their decision on whether or not to grant a discretionary pension increase.”
How would a base rate increase affect DB schemes?
Many experts predict that the Bank of England will shortly announce another rise in the base rate, from 0.75 per cent to 1 per cent, in order to tackle rising inflation.
Initial expectations were for a more significant hike of up to half a percentage point, but financial markets have since downgraded their expectations of the bank’s Monetary Policy Committee.
Though interest rate hedging, like inflation hedging, has been a feature of DB schemes in recent years especially, other issues around the rate increase could have an impact.
Elaine Torry, co-head of DB investment at Hymans Robertson, said: “For DB pension schemes the impact of any short-term interest rate [hike] is unlikely to move the funding dial. However, the rise in gilt yields which are happening concurrently cannot be ignored by these schemes.
TPR funding statement flags uncertainty impact for valuations
High levels of uncertainty surrounding inflation, interest rates, mortality, energy prices and economic growth will put additional pressure on trustees completing their tranche 17 valuations this year, according to the Pensions Regulator’s annual funding statement.
“The significant, circa 0.9 per cent rise in gilt yields that has been experienced since the start of the year, will be causing a greater impact. This increase in medium and longer-dated gilt yields could see liability values reduce by circa 15 per cent, leading to an average duration £100mn scheme facing a reduction in liabilities of circa £15mn as a result,” she explained.
“For those DB schemes that are not fully hedged against interest rate movements, this gilt yield rise could prove a much welcome tailwind for funding and present an opportunity to reduce risk and lock in funding gains.
“We would urge trustees to consider whether this recent movement is an opportunity to take further steps towards shoring up the funding position and protecting their members’ benefits.”
