Delaying retirement by a day could leave members £10,000 better off

A Bank of England update, published on August 17, confirmed that inflation has reached 10.1 per cent and is forecast to keep rising for the rest of the year, potentially to as high as 13 per cent.

The central bank suggested that the rate of inflation is expected to “slow down” next year, before falling back towards the targeted 2 per cent in “around two years”, although critics have pointed out that the BoE has severally underestimated inflation in recent times.

Analysis from XPS Pensions Group’s DB Funding Watch suggested that falling long-term inflation expectations have seen long-term defined benefit liabilities reduce by around £100bn over the past three months.

We’re seeing a lot of trustees reviewing the way that members’ benefits are calculated to ensure that no one loses out on these high inflationary increases

Charlotte Jones, XPS Pensions Group

Increases to member benefits, however, are calculated based on short-term inflation rates, due to be published later this year, when inflation is still expected to be in double-digits — something that may not be reflected in the retirement options available to members.

As a result, a member who is able to choose to retire in early-2023 could receive an additional inflationary increase equating to around a 7 per cent difference, or more than £10,000 of extra pension income over the members’ lifetime, when compared with a member who retires at the end of 2022.

XPS warned, however, that schemes will need to review their early retirement factors to ensure that members are offered fair value in light of high inflation.

XPS Pensions Group senior consultant Charlotte Jones said: “What a difference a day makes. A member retiring on January 1 could receive an additional £10,000 over their lifetime compared with December 31. As a result, at XPS we’re seeing a lot of trustees reviewing the way that members’ benefits are calculated to ensure that no one loses out on these high inflationary increases. 

“For example, early retirement factors, which reduce a member’s pension on early retirement to allow for the pension being paid for longer, may not offer fair value to members in this current high inflationary environment. As a result, we’re seeing many trustees adjust retirement quotes temporarily to ensure that members don’t miss out on vital retirement income,” she continued.

“We would recommend that all pension schemes take time to review the factors they have in place in the context of high inflation.”

Inaction could lead to a 7 per cent benefits cut

Geoff McKenzie, trustee director at Ross Trustees, explained that current inflation rates and longer-term expectations “underpin a number of the calculations of members benefits” in DB schemes, including early retirement and transfer values.

Inflation having been “very low” and “relatively benign” in the past 25 years has meant longer-term expectations have “been broadly aligned to existing inflation rates”, he said, adding that the current spike in short-term inflation “has upset this position”.

This has meant that trustees and advisers “have needed to consider possible short-term adjustments in transfer values and early retirement factors” in order to “ensure that the benefits provided to the member, in case they choose to retire or transfer their benefits in the next few months, meet legislative requirements and can be considered ‘fair value’ for the member”.

Jonathan Seed, scheme actuary and head of pensions strategy at Cartwright, told Pensions Expert that trustees “have a legal duty to be reasonably satisfied that the value of an early retirement pension is at least equal to the value of the pension that would be paid at normal retirement age”, and that September’s inflation figure is “critical” as it will be used to revalue deferred benefits in 2023.

Deferred pensioners are often the largest population in a scheme and are an ageing group, he explained. Cost of living factors are forcing members to consider transfers and early retirement.

“However, because of the lag between inflation happening and deferred benefits being revalued, there is a risk that members who retire early or transfer out later this year miss out on what is effectively a known inflationary increase of 10 per cent or more,” he said.

This could lead to a reduction in benefits of 7 per cent, “or potentially even more if inflation continues to increase”.

Seed said that “an adjustment” would have to be made to forestall this eventuality. Though the precise nature of it will vary from scheme to scheme, he stressed that trustees “should take action to ensure members are protected and get fair value”.

Trustees ‘must consider restrictions’

Dalriada professional trustee Adrian Kennett told Pensions Expert that the way early retirement factors are applied is usually determined by a scheme’s trust deed and rules, and that it is “not unusual” to find these laying out that early retirement factors are set “by the trustees having considered the advice of the scheme actuary”, though some will also require the consent of, or consultation with, the sponsoring employer.

“Factors are usually set following completion of an actuarial valuation, which generally happens once every three years. Inflation, as measured by the consumer price index, is currently running in excess of 10 per cent per annum,” he said. 

“Trustees may have in force early retirement factors which assume a long-term rate of inflation of perhaps 4 per cent per annum, because that was the assumed rate when they completed their last actuarial valuation. The current rate is priced by markets to be temporary, as long-term inflation rates are far lower.”

Additionally, when calculating early retirement benefits from deferred status, “the benefit is revalued to January 1 prior to retirement and then the factor is applied”, Kennett said, meaning that “a member who retires on December 31 2022 has their pension revalued to January 1 2022 and doesn’t benefit from the 10 per cent uplift that would be applied from January 1 2023”.

“They benefit from the assumed long-term uplift, but not the actual experience, which is considerably higher,” he said.

He added that this had led some actuaries to point out this inequality, and to advise trustees to “temporarily uplift early retirement pensions taken in the latter half of 2022”, though he stressed that they would have to be “reasonably satisfied” that the alternative offered “is of at least equal value to the short service benefit that would otherwise be payable”.

“So, legally, trustees should at the very least be considering the impact of inflation on calculations such as early retirement pensions. It should, however, be noted that the value being offered is based on assumptions, and it could be argued that those assumptions remain appropriate in the round,” Kennett said.

He also pointed out that trustees would need to consider “whether there are restrictions on what they can do, which there may indeed be if the rules of the scheme require employer consent to the determination of the early retirement factors”.

“Trustees will also need to have consideration for the funding implications of adjusting members’ benefits, but usually the uplift applied is considered to be cost neutral.”

He added that transfer value factors would also require “particular attention”, as the value of deferred pensions faces “a cliff edge” at January 1 2023, “and it is important to consider whether that uplift should be factored into the consideration of transfer values paid”.

“As a minimum, trustees should consider alongside their advisers and possibly their sponsor whether a communication should be issued to members around the topic of high inflation/cost of living, especially if they have enquired about accessing their pension scheme benefits,” Kennett continued.

“While pension increases in payment are often capped on an annual basis, the revaluation of deferred pensions is usually capped over the whole period. As one commentator noted, given historic low levels of inflation, we’d need to see extremely unusually high levels of inflation before we get to the point where average inflation over several years exceeds this 5 per cent per annum cap.”