Government proposal could slash Defined Benefit pension incomes

‘Reforming’ how increases in income are calculated would have a big impact on people with Defined Benefit pensions.

Defined Benefit pensions aren’t as prevalent as they once were.

These pension schemes reward members with a guaranteed annual income, calculated as a percentage of their salary during their working days, based on their years of service with a particular employer.

They have generally been phased out now, replaced by Defined Contribution schemes, where pension savers take on all of the risk in how their money is invested and have to make the best of whatever pot they end up with.

However, just because Defined Benefit schemes aren’t on offer anymore to new savers, there are still thousands of older people up and down the nation sat on one right now.

And a proposed change from the Government could see the incomes those pensioners enjoy sliced significantly.

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Ditching RPI

It all comes down to the Retail Prices Index (RPI) measurement of inflation. It’s not hugely well-liked by organisations like the Treasury and the UK Statistics Authority, as they take issues with aspects of how it is calculated. 

Instead, they want to see it replaced with a more comprehensive version of the existing Consumer Prices Index (CPI) that includes the housing costs of owner-occupiers (CPIH) , which they believe is more accurate.

The Government is now consulting on how to ‘align’ RPI and CPIH, with the plan of doing so at some point between 2025 and 2030.

And this move will have a significant impact on the pension incomes of many older people across the country according to a new report from the Pensions Policy Institute (PPI).

Of course, this isn't the first time the Government has used inflation to benefit their coffers at our expense.

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Why this will hurt pensioners

Part of the reason RPI has lost popularity is that it goes up faster than other inflation measurements.

The report from the PPI suggests that RPI has increased by around 1% more each year since 2011 than both CPI and CPIH.

However, many defined benefit pension schemes invest some of their funds in RPI-linked gilts and other RPI-linked assets, while the PPI found that around two-thirds of schemes uprate the benefits for members in line with RPI.

Obviously, if RPI gets reformed so that it is closer to CPIH, this will damage the return on those investments, as well as cut any increases to benefits scheme members normally enjoy.

This isn’t going to be a small change either. 

Let’s take an example from the PPI report of a 65-year old man right now, with an average life expectancy of 86.

With current PPI uprating, their yearly average income from a defined benefit scheme would be around £6,300 but would drop to £5,200 if the change took place from 2025 (a 17% fall) or to £5,500 if the change took place in 2030 (a 12% fall).

The impact is even greater on women, thanks to their longer life expectancy, with a drop of 19% if the change happens in five years or 14% if it takes a decade to go through.

And these are just the averages – in some cases pensioners will see their incomes drop by even more.

What’s more, the report argues that the change will also impact the value of investments held by these defined benefit pension schemes, potentially leading to more schemes falling into deficit.

As Tom McPhail, head of policy at Hargreaves Lansdown, puts it, if you have joined a pension scheme expecting to receive RPI-linked increases to your income, you should continue to get those benefits.

“Arguing that they’ll still receive an RPI-linked benefit but then changing the definition of what RPI means, is a bit of Alice in Wonderland logic; it looks like it could be an April Fool but for anyone facing the prospect of losing up to 21% of the value of their pension, this is no laughing matter.”

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What’s the alternative?

There are options open to the Government which would mean they could reform RPI without slashing pensioner incomes.

One mitigating measure suggested by the PPI is to publish a ‘spread’ which would be calculated “to reflect the expected long-term average difference between RPI and CPIH”. Then gilts and benefits could continue to pay out at the index measurement, plus that spread.

The Government could then use this ‘new RPI’ for all new contracts entered into after the change takes place.

Can I do anything?

Unfortunately, there’s not a huge amount you can do directly. 

But as McPhail argues, it’s always important to take inflation into account when planning your long-term finances, particularly as you move into retirement. 

Blending your income, by using a combination of the State Pension, annuities, a company pension income (if you have it) and drawdown can help you offset inflation, even if only partially.

McPhail adds: “A drawdown plan invested in equities should generate a rising income thanks to economic growth and rising company dividends over time.”

But for those who don’t have that luxury, this change is likely to mean they need to strive to make their incomes go further by being more proactive in reducing their household bills.