For the first time in decades, the UK has had short periods where the retail prices index (RPI) has been negative, causing deflation. Naturally, there is concern about whether this is a short-lived issue or the start of a sustained period of deflation.
How does deflation impact upon pension schemes? Traditionally, RPI has been used to calculate statutory revaluation, as well as statutory and non-statutory increases to pensions in payment. With the arrival of deflation based on negative RPI, can trustees reduce pensions?
There is scope for the Government to disregard negative RPI when setting statutory revaluation and pension increases (by applying an alternative, positive, index). However, even if the Government chooses to apply negative RPI, Wragge & Co's Pensions team believe that it is highly unlikely that trustees will have scope to reduce deferred pensions or pensions in payment. Our pensions experts look at the impact of this for deferred members and pensioners.
What pension rights does deflation impact upon?
Inflation and deflation has an impact upon:
a.statutory revaluation applied to deferred benefits since 1986;
b.statutory pension increases on guaranteed minimum pensions (GMPs) earned between 6 April 1988 and 5 April 1997;
c.statutory pension increases on all defined benefits earned after 5 April 1997;
d.statutory pension increases on all money purchase pensions which came into payment before 6 April 2005; and
e.any pension increases applied to benefits earned before 6 April 1997 under the scheme rules.
What does the law provide?
There has been much talk in the press about whether or not pensions can be reduced to take account of deflation. However, the first question is whether deflation will actually apply to pension schemes at all.
For statutory revaluation and statutory increases on pensions in payment, the increases are effectively set by the Government. Importantly, the Government is not required by law to use RPI. Traditionally, it has used RPI to match Inland Revenue requirements which applied up until April 2006 but not beyond.
For both revaluation and statutory pension increases, the Government will determine what prices index to use. If the Government does not use RPI, benefits have to be calculated in line with the prices index the Government selects. While RPI has been negative, other key price indices have been positive. So, it is open to the Government to ignore negative RPI figures and apply inflation instead by using an alternative index.
No one knows if this will be an issue until the RPI figures for September are published. If September is a deflationary month, only then will we see whether the Government is prepared to issue negative figures or will plump for an alternative index producing a positive figure requiring an increase to benefits.
What about scheme rules and non-statutory increases?
For non-statutory pension increases, the scheme rules will prevail.
Each scheme will be in a slightly different position and a review of the rules is essential.
Pension increase rules usually refer to pension increases being "added" to benefits and apply those "increases" by reference to 12 month review periods using RPI. It is very rare to see less specific wording or to see provisions which would allow deflation to be taken into account.
Can benefits be reduced?
The straight answer is no.
If RPI is negative and is selected by the Government for statutory revaluation and statutory pension increases, it is still unlikely that trustees will be able to reduce deferred pensions or pensions in payment by applying negative RPI to them. This is because all of the legislation refers to increases or to benefits having amounts added to them (thus, contemplating inflation only). Trustees are required to comply with the letter of the law, which in our view does not permit pensions to be reduced.
For non-statutory increases, it is extremely unlikely that trustees will have the power to apply deflation to benefits and reduce them. This is because rules are usually drafted in terms which provide for increases to be given.
What's the impact - deferreds?
For deferred pensioner revaluation, a short period of deflation is unlikely to make much difference to most members or schemes. This is because revaluation is measured over a long period of time. Therefore, assuming deflation is provided for in the Government's orders, it can effectively be offset against inflation. The position will be of more concern to deferreds if we see a sustained period of deflation.
For those deferred members who have only ever experienced deflation or where the rate of deflation outstrips the rate of inflation, their deferred pensions should be frozen, rather than reduced.
What's the impact - pensioners?
For pensions in payment, deflation means that in the vast majority of cases the pensions will need to be frozen. By not being able to take deflation into account (either immediately or by offsetting it against future inflation), the value of pensioners' benefits are, effectively, increased above the level of benefits intended to be provided.
The only way for the balance to be redressed would be for the UK to experience a period of inflation above the relevant pension increase caps which would, in turn, effectively reduce the value of benefits.