Inflation bursts through indexation cap

FINAL salary pension payments in the private sector failed to keep pace with inflation last month for the first time since the latest indexation rules were introduced in 1997, according to Towers Watson.

Retail Price Inflation was 5.3 per cent in the 12 months to April 2010, the first time it has broken through the 5 per cent ceiling which applies to inflation-linked increases to defined benefit pensions earned between 1997 and 2005, says the consultancy.

Public sector pensions offer full indexation. But twelve-month RPI was negative between March 2009 and October 2009 and defined benefit pension increases based on inflation in these months were generally zero, although in a handful of cases, payments were reduced.

Rash Bhabra, head of corporate consulting at Towers Watson, says: “Inflation is good for borrowers and bad for lenders. In a defined benefit pension scheme, the members have effectively lent money to their former employer by agreeing to accept a pension in future in return for work they have already carried out. A sustained period of high inflation would make pension liabilities less of a burden on companies but would mean scheme members did not enjoy the standard of living they had expected in retirement.

“If inflation were to rise further and stay high for some time, there would be different outcomes for public sector and private sector pensioners. Public sector schemes provide full inflation increases, whereas private sector defined benefit schemes generally apply a cap.

“However, the biggest losers would be people who had saved in defined contribution pensions and used the money to buy a level annuity. People making that choice get a bigger income to start with but their pension will not rise even if inflation goes through the roof.”