UK defined benefit (DB) schemes may face difficult decisions later this year around whether to grant inflation-driven discretionary increases, with an £8bn (€9.5bn) increase in liabilities across private sector schemes on the cards if inflation remains at current levels, according to Aon.
If, as expected, inflation is above 5% in the key reference month of September, DB schemes will need to know who has the discretion in their scheme rules to decide whether or not to provide increases above any cap.
Most DB pension payments in the UK are linked to inflation and rise in line with the Retail Price Index or Consumer Price Index up to a maximum of 5% per annum and with a floor of 0%.
“A potentially tricky situation is looming and schemes need to be clear from a governance perspective on where the decision sits,” said Lynda Whitney, partner at Aon.
“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.”
She added: “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.”
The last time RPI was higher than 5% was in 2011 and schemes were typically in a very different position then, Aon said.
For example, not only did they have higher technical provisions deficits, but DB schemes today are trying to aim for long-term targets they are still significantly short of and also have much higher inflation hedging levels.
Another notable difference, according to Aon, is that in 2011 inflation only briefly moved above 5% so was “not a factor high in the public consciousness”, and the UK state pension is currently expected to go up by the “triple lock” which does not contain a cap.
“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,” said Whitney.
“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.”
According to Raj Mody, global head of pensions at PwC, the surplus trend for UK corporate DB schemes is set to continue with inflation still rising. He said around nine out of 10 schemes have limits on how much inflation they pass into pension increases and that for nearly all of these 4,500 schemes, this cap will be lower than the current rate of inflation.
Mody’s colleague Laura Treece, pensions actuary at PwC, said some sponsors and trustees were thinking about how they might help their pensioners and that some were actively considering paying discretionary top-ups to pensions if inflation rates remained elevated.
“This is something we haven’t seen much of recently – discretionary increases were more common in the 1990s when there was no compulsory requirement for pension payments to go up each year,” she said. “We may start to see more and more schemes bringing back this practice if inflation remains high.”