This month's Off The Record looks at the issue of the indexation of pensions.
Indexation is one of those issues that divide working members of the population from retired people, and active members of occupational pension schemes from retired or deferred members. For the active members, unconditional indexation is seen as robbing Peter to pay Paul. For state pensioners the argument is not whether indexation should be conditional, but whether their pensions should be linked to wages rather than prices
Pensions indexation is central to sustaining public confidence in pensions, public and private. Jaap Maassen, vice-chairman of the European Federation for Retirement Provision, has declared: "As far as I am concerned indexation is the difference between a good pension and a bad pension."
In western Europe, only Denmark and Switzerland (supplementary pensions), Ireland and Portugal do not have a form of indexation.
Yet the principle of indexing pensions in payment has been under pressure over the past decade. There have been three broad developments.
The first is the move from pension indexation linked to wages to indexation linked to prices, or to a combination of both. Finland, for example, has gradually moved from a wage indexation to a price indexation of earnings-related supplementary benefits. The second is the move from guaranteed to conditional indexation. In the Netherlands, pensions experts have concluded that guaranteed indexation was virtually unaffordable under the new FTK supervisory regime.
The third development is the move from mandatory indexation to voluntary. Currently three west European countries - Germany, Finland and the UK - have mandatory indexation of pensions in payment. A recent survey of occupational pension funds by the UK National Association of Pension Funds found strong support for moving from mandatory indexation to a system of conditional increases to pensions in payment.
These developments have met with resistance. Pensioners' groups argue that switching from wage to price indexation is unfair to retirees because it erodes the value of pensions when wages go up. Wage indexation, however, maintains the relative position of retirees and gives them a share in productivity growth.
There are signs that European governments are listening to these arguments. The UK government has said that it intends to restore the state pension link to the wages index by 2012.
Dutch social affairs minister Piet Hein Donner has said that pension funds will not be allowed to use excess reserves to reduce contributions at the expense of any promised indexation.
So is indexation a necessary protection of the value of pensions in payment or an unjustified drain on pension fund assets and a threat to the pensions promises of active members? We wanted your views.
The overall view of the pension fund managers, administrators and trustees who responded to our survey is that indexation is important, but has to take account of the government's or the sponsor's ability to pay. Many feel it is important to distinguish between the application of indexation to first and second pillar pensions.
One manager points out that "there is a need to distinguish state pensions - where there is a social purpose and a link to earnings can be seen as desirable - and company voluntary pensions, where the company should be able set up benefits as it sees fit in consultation with employees". This puts the defined benefit (DB) scheme at a disadvantage to a defined contribution (DC) scheme, he suggests. "The absence of indexation is a problem for DB pensions, since the inflation risk becomes impossible to manage for the member. A DC pension is more able to accommodate it."
Opinion is evenly divided about whether the indexation of pensions in payment against inflation should be mandatory, with a small majority (53%) in agreement. Again, respondents see a need to distinguish between the different imperatives of state and company pensions.
A Spanish pension fund manager points out: "It depends on whether its is a basic pension - in which case the answer must be yes for indexation - or a supplementary pension. It is also necessary to know what is the role of both."
Some occupational pensions schemes, such as the Shell pension scheme in the Netherlands, are careful to point out that, although the company guarantees to provide a level of indexation if certain conditions are met, members do not have a right to indexation.
Yet almost two-thirds (63%) of the respondents think that pensioners should have a basic right to pensions indexation to protect their pensions against the effects of inflation. However, this is felt to apply more to first than to second pillar pensions. As one manager remarks: "They should have a right to indexation if it is a basic pension."
There is strong support for the conditional indexation of occupational pension schemes, a feature of the Dutch pension system. Four out of five managers (79%) think that the indexation should be conditional on the pension fund's ability to pay.
One UK pension fund manager comments: "It is fairer that all fund members are treated equally rather than some getting guaranteed increases while others' pensions become eroded, possibly completely."
The idea that pensions in payment should be linked to an earnings index rather than a consumer price index finds little support, with three in four managers (74%) against such a switch. Four out of five managers (79%) think that prices are the best yardstick for pensions in payment.
Only one in three managers (32%) think that linking pensions in payment to a consumer price index rather than an average earnings index will result inevitably in a reduction in their value.
One manager sees a pension linked to average earnings as desirable but unaffordable. "It could be an aspiration but it is better to have a guaranteed index that can be afforded over the long term with increases above that only if the fund is in substantial surplus."
Another points out that a pension linked to price inflation should be adequate if other forms of social security are available: "The link to inflation could be enough if the healthcare and dependency costs are publicly covered."
There are alternatives to price-linked pensions, however. One pension fund manager suggests linking indexation to the long-term, smoothed performance of the pension fund assets.
Opinion is divided about whether pensioners should benefit from the economic growth - in terms of rising wages - that they themselves have helped to create, with almost half (47%) in agreement and rather than less (42%) disagreeing.
There is a feeling that the relationship between pensioners and the national wealth is more complex. As one pension fund manager says: "The share of the prosperity among generations has many other features to take into account."
Another comments dryly that the suggestion that pensioners are responsible for current prosperity "remains to be proved".
Generally, opinion is that pensions should not be linked to wages. More than two-thirds (68%) agree with the proposition that, "since pensioners are not in the workforce they should not be treated as if they were. Everybody is affected by prices, but it is only the efforts of people who are working that determines the size of pay packets". Yet not all agree. One manager suggests that this is "too simplistic an argument".
Most respondents (80%) think that linking pensions in payment to an average wage index is unfair to the active members of a pension scheme, in terms of reducing the pension fund assets available for investment. However, one manager points out: "It depends on what basis contributions were made for those now receiving pensions."
The OECD's suggestion that the best form of pensions indexation, from both the pensioners' and government's point of view, may be a combined wage and price index finds little favour, with only one in five managers (21%) agreeing. Such a compromise would be "overly complex", one manager suggests.
Mandatory indexation is clearly seen as an unnecessary burden on plan sponsors and a further argument for moving from DB to DC pension arrangements. Four in five managers (79%) think that moving from mandatory to voluntary indexation would help to ensure the survival of European DB schemes.
Yet 68% feel that reducing, or even abolishing indexation will do little to reverse the decline of DB schemes in Europe. "The trend has gone too far", one manager observes gloomily.
So perhaps the issue of whether pensions should be pegged to prices or wages will become a purely academic one.