In June 2010, the Government announced that private sector defined benefit (DB) schemes would be able to use the consumer prices index (CPI) rather than the retail prices index (RPI) as the measure of inflation for calculating pension increases. The change is due to take effect on 6 April 2011 and coincides with a similar change being introduced for public sector and state pensions.
To put this change into context, on 14 December 2010 the National Statistics Office announced that the annual change in inflation based on CPI was 3.3%, with RPI much higher at 4.7%.
The Department for Work and Pensions (DWP) issued a consultation document on the impact of using CPI in private sector schemes on 8 December 2010. On 13 January 2011 the Government published draft legislation in the Pensions Bill 2011.
In this article we examine the position in detail, exploring whether your scheme may be able to take advantage of the switch to CPI.
When is RPI used in a scheme’s benefit structure?
This depends on the type of scheme. In DB schemes, RPI is used to calculate increases to pensions in payment and to revalue deferred pensions before they come into payment. In many career average re-valued earnings (CARE) schemes, RPI is also used to revalue, on a year by year basis, annual ‘slices’ of accruing pension for active members.
Also, in some trust-based defined contribution (DC) schemes, RPI is used to calculate increases to pensions in payment where members are permitted to secure a pension within the scheme.
The difference between CPI and RPI
CPI is based on the HCIP (Harmonised Consumer Index Prices) which measures inflation on internationally agreed standards throughout Europe. It is based on a wider sample of the population than RPI. It is also the measure used by the Bank of England.
The difference between the two measures relates to the items chosen for the basket of goods used and the weight that is taken into account in the calculation of each of those items. Most significantly CPI does not include council tax or mortgage interest repayments, both of which are included for measuring RPI.
The National Statistics Office has issued a bulletin explaining the differences between RPI and CPI, and giving detailed information about the position as at 30 November 2010. Go to: http://www.statistics.gov.uk/pdfdir/cpi1210.pdf
What do your scheme rules say?
The drafting of occupational DB scheme rules, typically, fall into the following three categories:
- The Rule refers to the relevant pension legislation, without embellishment
eg “Pensions in payment will increase to the extent required by Section 51 of the Pensions Act 1995.”
- The Rule refers to the relevant pension legislation, but seeks to explain the statutory requirements
eg “The increase to the deferred pension will be calculated in accordance with Chapter II of Part IV the Pension Schemes Act 1993 (based on the lower of the annual percentage increase in the retail prices index and 2.5% p.a.).”
- The Rule tracks exactly what pension legislation currently requires but does not refer to the underlying legislation
eg “Pensions in payment in excess of any guaranteed minimum pension are increased in line with the percentage rise in RPI to 30 September with a maximum of 2.5% a year.”
It is fairly typical for pension increase and deferred revaluation rules to be drafted differently. So, you might have a deferred revaluation rule that falls within category 1 but a pension increase rule that falls within category 3. If both your rules fall into category 1, you will be able to take advantage of the switch to CPI without making any rule amendments. Increases to guaranteed minimum pensions (GMPs) will usually fall within this category.
If your rule falls into category 2 you should seek legal advice. It is arguable that any helpful explanation of what the statutory requirements were when the rule was drafted does not form part of the operative provisions of the rule. But legal views differ and the exact wording of your particular rule will be crucial.
If your rule falls into category 3 and you want to switch to CPI, you will need to seek legal advice about what, if anything, you can do. With these types of rules, it is likely that you will only be able to switch to CPI in respect of future service pension accrual, if this is permitted by your scheme amendment power.
Three key questions asked by clients
Question one: Will the Government include a provision in the new legislation requiring trustees to apply CPI (rather than RPI) automatically? If such a ‘statutory override’ is provided, it will enable employers and trustees to switch to CPI without needing to amend scheme rules. As the majority of scheme rules expressly refer to RPI, without it, a switch to CPI would require a rule change.
Answer: The DWP consultation document emphatically states that no statutory override will be introduced for the switch from RPI to CPI, although the Government “welcomes views on whether there is any justification for overriding scheme rules of private sector pension schemes”. The consultation runs until 2 March 2011. Unsurprisingly, the Pensions Bill 2011 contains no statutory override provision.
Question two: If no statutory override is introduced, will it be possible for scheme rules to be amended to switch from RPI to CPI for both past and future service pensions? To enable schemes rules to be amended in this way the Government would need to introduce an exemption to Section 67 of the Pensions Act 1995, but will it do so? Section 67 prevents changes to private sector pension schemes which “would or might adversely affect” members’ accrued rights.
Answer: The Pensions Bill contains no modification power to allow schemes to use CPI in situations where Section 67 would otherwise apply but the DWP “welcomes views on whether it is right to rule out granting modification powers”. As Section 67 would apply to any changes, this would preclude rule amendments that apply CPI to accrued benefits (including deferred pensions).
Question three: Will trustees be forced to provide increases based on the better of RPI and CPI (a ‘CPI underpin’)? In September 2009, CPI was greater than RPI, so the possibility is not theoretical. This is concerning those employers who want to maintain the status quo by continuing to use RPI.
Answer: The Pensions Bill Government permits a scheme to continue to use RPI for pension increases and/or revaluation of deferred pensions, without having to apply a CPI underpin.
Proposed employer consultation requirement
In the consultation document, the DWP proposes a 60 day consultation with affected members for those wishing to change their scheme rules to adopt CPI. In theory, this should mean that employers and trustees who adopt CPI on 6 April 2011 because their scheme rules simply refer to the relevant pension legislation (ie their rules fall within category 1 above) would not be caught by this new consultation requirement.
However, the draft legislation attached to the consultation document is too widely drafted and appears to catch so-called ‘automatic’ adoptions of CPI. This is because the proposed wording for this new listed change refers to changing the rate at which pensions are increased/re-valued. This is wide enough to capture switches from RPI to CPI, whether as a result of a rule change or not.
Employers with large pension scheme deficits who were hoping to take advantage of the switch to CPI (in the same way that the Government itself has done in the public sector), will be disappointed if their scheme rules expressly refer to RPI. Without a statutory override or modification power, those employers will only be able to make the switch for future service, if their amendment power permits.
To access the Pensions Bill 2011 go to: http://www.publications. parliament.uk/pa/ld201011/ldbills/037/2011037.pdf Explanatory notes are available at: http://www.publications. parliament.uk/pa/ld201011/ldbills/037/en/2011037en.pdf To read the consultation document go to: http://www.dwp.gov.uk/docs/cpi-private-pensions-consultation.pdf
The current position on listed changes is set out in the Occupational and Personal Pension Schemes (Consultation by Employers and Miscellaneous Amendment) Regulations 2006 (S.I. 349) as amended by the Occupational and Personal Pension Schemes (Miscellaneous Amendments) Regulations 2010 (S.I. 499).
Seek legal advice on your scheme rules
Check whether your scheme rules mention RPI. If the rules simply refer to pension legislation, you may be able to switch to CPI without further action in order to reduce any deficit.
Have your say before 2 March 2011 deadline!
Send your e-mail response (stating the name of your organisation) to [email protected], marked for the attention of Michelle Boreland.