Deflation: the obligatory image of balloons to illustrate our relatively poorer pensioners
Today’s announcement that the consumer price index (CPI) has seen a decrease (-0.1%) over the past year will be bad for both current pensioners, and many individuals with final salary benefits.
CPI is the government’s preferred measure of inflation; cynics might say this is because it has historically been lower than the retail price index, the other principal measure of inflation. It is certainly lower than the “PPI” the true cost of pensioners’ price inflation which, by my reckoning, may well exceed 5%.
Those receiving a State Pension
The basic State Pension increases every year by the highest of:
- earnings – the average percentage growth in wages (in Great Britain)
- prices – the percentage growth in prices in the UK (CPI)
Provisional figures on the earnings index are at 2.9% suggesting this might be the relevant measure this year, with a basic state pension rising from £116 per week to £120 per week.
Those with final salary pension savings
CPI is the measure used to test the real value increase in a final salary member’s pension benefits. For money purchase scheme this is simply the value of the contributions paid during the pension input period (which for, simplicity, is now generally the tax year). However, under a final salary scheme it is the increase in the value of a pension rights during the pension input period.
For final salary members, it is the change in CPI September to September that is relevant. The reason for this comparison is to avoid penalising members for ‘cost of living’ increases. For active members this means modest payrises, promotions or additional years’ service can have a huge impact, and commensurate tax charges.
The calculation is not generally prepared by scheme members, and we would suggest the pension scheme administrator does it. However it can be useful to assess your position mid-year, for this reason it is worth knowing how it is calculated:
- Take the annual pension amount at the beginning of the pension input period (ignoring early retirement penalties – it is assumed the member is at normal retirement date).
- This value is multiplied by a fairly arbitrary valuation factor of 16.
- Any lump sum is added on
- Then the total value can be increased by CPI over the 12 month period to the September
- This total is deducted from the benefits at the ending of the pension input period (no increase in value applies here, but is otherwise calculated in the same way)
For most individuals they will have a £40,000 annual allowance, or £2,500 per annum allowable increase. However we are anticipating new rules from 6th April 2016, with more complex transitional rules which further compound this complicated area.
In the current year, for those drawing state pensions, the very low CPI means, in all likelihood, average earnings becomes the most generous measure to increase their pensions; this actually bears no resemblance to the real cost of living increases retirees see, but is arguably more generous than a CPI-only link.
The rules surrounding DB pensions are particularly complex, and with interference from other factors such as the lifetime allowance, we would suggest tailored advice should be sought. Annual and lifetime allowances are falling for many from 6th April 2016, and this very low CPI could be the factor that tips some individuals into opting out of otherwise valuable DB schemes, which is very unfortunate. Making the decision to opt in or out should never be done without advice, and we have specialists who can help.