The writing hand of Mervyn King must be feeling the strain of the inflationary pressures in the UK’s economy. For six quarters in a row, the Bank of England Governor has found himself in the position of having to draft a letter to Chancellor George Osbourne to explain why the Government inflation target has been missed. It may be unfair to blame Mr King as many think that the Chancellor’s target is unrealistically low, including Mr Osbourne himself who seems to accept high inflation as a reality we have to live with for the time being.

High inflation is not always bad – it can encourage economy-boosting spending and more private investment in companies as many investors see stocks and shares as a better option than cash. Unfortunately, it also provides a lot of instability in the economy and the world of pensions. Over the last year, inflation has been the biggest issue on our radar, not least because of the contentious legislation to determine pension valuations based on Consumer Price Index (CPI) rather than the previous gauge of Retail Price Index (RPI) being introduced in the UK.

The recent announcement that CPI rose by 4.5 per cent over the last year compared with an increase in RPI of 5.2 per cent will have a direct economic impact on many pensioners. Those with pensions linked to RPI would gain by almost one per cent each year compared to those with pensions linked to CPI.  Assuming these inflationary rises continued at their present rates, the income of a pensioner currently earning £10,000 each year would rise to just over £16,600 per annum in ten years time under RPI compared with around £15,500 per annum under CPI.

Inflation as it impacts on pensioners is generally accepted to be currently relatively higher as the ‘basket of goods’ includes many items which have increased more rapidly recently, such as food and fuel costs. These tend to represent a greater proportion of income spend for a pensioner whereas other areas of expenditure which have been more stable or reduced.

The current high levels of inflation are highlighting the controversy over the move from RPI to CPI. We have already seen many public sector union leaders calling for a judicial review on this decision and the private sector is not exempt from this either. British Airways have seen three trustees of the pension fund in April resign because of the move from RPI to CPI.

Future movements in CPI are very difficult to predict.  Even over recent years, there have been a number of occasions that CPI has exceeded RPI so it can therefore not be ruled out that CPI could on occasion give rise to higher increases than are currently paid under RPI.  The basket of goods for CPI could also change – if, for example, housing costs are included, this could substantially close the current gap between it and RPI.

Looking at the impact of inflation from a different perspective, it can also have a roller-coaster effect on pension scheme payments and funding levels.  Inflation caps on pension increases are often overlooked.  Pensions may become significantly devalued if this cap applies for an extended period (irrespective of whether the inflation measure is CPI or RPI). Pension increases are generally capped at a maximum of 5% per annum, and so with inflation at its current level, capping at the 5% level would currently apply under RPI and remain a distinct possibility for the future.

While it would be bad news for pensioners and possibly the wider economy, a run of higher inflation is actually likely to improve scheme funding. Providing the actual inflation level exceeds any cap that a scheme has in place, it will be providing its members below inflation increases which, assuming investment returns do keep pace with inflation, will improve the overall funding of the scheme. The worst possible scenario for scheme funding is likely to be in a period of deflation whereby they would need to effectively pay out increases in excess of inflation and reduce scheme funding.

Perhaps the fine balancing act and the cause and effect implications of rising inflation explain the apparent willingness of the Bank of England and the Government to live with this situation, at least in the short term. However, the longer Mervyn King is required to pen an inflation letter to the Chancellor, the greater impact this will have on UK pensioners.

This article featured in the Scotsman on 24th June 2011.

I came across an interesting panel discussion in the current issue of Engaged Investor Magazine, where a number of industry experts were asked for their views on developments in pension scheme de-risking. My views on the questions addressed are as follows:

Q1 – Many companies are not able to carry out full buyout in one go. What multi-layered approaches can they take to de-risk their schemes?

The most important first step is for the employer and trustees to agree a common goal for the scheme. In almost all cases (especially closed schemes), the ultimate goal should be to secure all benefits with an insurance company and wind-up the scheme.

An agreed, transparent objective will then set the path towards the ultimate goal. There are many alternative partial de-risking measures that can be taken, most of which can work in parallel. These include employer led exercises such as:

• a transfer exercise, offering members the opportunity to transfer their scheme benefits to an alternative arrangement via an incentive in the form of an increased transfer value, or sometimes a cash payment; or
• a pension increase swap exercise, where members give up future pension increases in return for a higher initial pension.

These exercises can generate significant savings to the employer relative to the ultimate cost of buyout. They are unlikely to generate significant immediate savings on ongoing funding costs or FRS 17, though they do contribute to reducing the risk profile of the scheme.

These exercises can be run in tandem with providing opportunities to members to retire early from the scheme, which can generate savings on cash commutation and also insurers prefer the “certainty” of pensioners rather than deferred members. In conjunction with the company, the trustees can also move towards a lower risk investment strategy, using bonds or LDI type investments, and also consider partial insurance such as pensioner buy-ins. I would caution that for schemes with young pensioners or where the pensioner group makes up a small proportion of the liabilities, it may not be efficient to use significant resources of the scheme to obtain insurance covering only a small portion of the liabilities. There are also opportunities developing in the market to enter into a staged buyout process with insurers, where the terms are agreed up front but the whole premium is not required at the outset.

Nor should the trustees overlook the potential for non-cash funding, such as parental guarantees, contingent assets or “asset-sharing” with the company, such as the whisky-bond deal completed by Diageo .

Q2 – In what ways did trustees’ de-risking choices change during 2010?

The choices remained broadly unchanged, though it was a year of massive change in defined benefit pensions, particularly on the legislative front. The single largest issue was Steve Webb’s RPI/CPI summer bombshell, which is expected to have a significant effect on pension scheme funding. Most schemes are expected to see a reduction in liabilities of between 5-15% depending on the nature of the scheme rules.

This meant that larger exercises tended to be shelved as trustees waited for the full impact of the change in inflation measure to come through. I would say the introduction of innovative non-cash funding solutions and the focus by trustees on obtaining enforceable security was the other main development in de-risking.

The emergence of longevity swaps was supposed to be the big-ticket item for 2010, but this remains the preserve on the very largest of schemes and I don’t see that changing any time soon.

Q3 – What early steps, such as data cleansing, communications and legal considerations, should be undertaken before entering into a de-risking activity?

The quality of pension scheme data can be highly variable. It can be held in multiple formats, for very long periods of time and is often subject to major change (e.g. after mergers, systems migrations, legislative changes). When entering a liability management exercise and moving ultimately towards winding-up a scheme, every effort must be made to ensure that members have the correct pension entitlement. The key message on data is that full and accurate data will reduce the cost of staff communication and liability management exercises as well as ultimately buying annuities as it helps to reduce underwriters’ pricing for uncertainty.

The communication process is also vital, both between the employer/trustees and the member. Possibly even more important is the communication between a financial advisor and the member during an employer’s de-risking exercise.

The need for proper legal input almost goes without saying, but the emergence of the RPI/CPI issue and continued problems with sex equalisation and other scheme amendments, mean that assistance from your friendly pensions lawyer is a necessity, not a luxury.

Throughout my work in the pensions industry, I find myself continually being surprised by the effects of small print, either in scheme rules, insurance policies or in the legislative framework governing pension schemes. So you would think that I always check the finer detail.

And if you can’t remember to check the small print, at least remember “case law”.

But alas, before embarking on my return journey home to Glasgow from nearby York on Wednesday, I did neither.

To help control my employer’s expenses, I did some research and found that purchasing an advance single train ticket from York to Glasgow for my return journey was the most cost effective approach. On departure from the meeting, I was offered a lift by car to Darlington (heading in the right direction) where I could connect with my train. Good idea, yes?

On arrival at Darlington, I checked at the ticket desk – “My ticket is still fine, given that I’m catching the same train?” Simple answer, surely, but always polite to check. The response was a bit of a shock. The lady behind the desk, I didn’t catch her name – let’s just call her Mrs Jobsworth, said “No, that would count as a “broken” journey . You would need to go back to York to catch the train but you’ll be too late. It will cost £40 to change the ticket over.” I was then handed a leaflet containing said small print which confirmed I had to start and end my journey at the stations stated on the ticket. The fact that I was using their services for a lesser period didn’t seem to count.

Now in my mind, travelling back to York to try and catch a train which will shortly arrive in the station I was actually in struck me as possibly one of the most stupid suggestions I had ever heard. Mrs Jobsworth’s final suggestion was that I could just “chance my arm” to see if I got away with it. My predicament did eventually remind me of a staggering piece of “case law” – that of Professor Martyn Evans, who was charged an additional £155 by the same train company for getting off a stop early compared with the destination on his ticket (it was subsequently waived).

So chance my arm I did, and low and behold, an outbreak of common sense. I took my seat (which was no doubt unused between York and Darlington), I gave a truthful account to the conductor and he said “It’s the same train you are on, so no problem”. I didn’t try to correct him with Mrs Jobsworth’s small print.

Lessons Learned

1. Always check the small print;
2. Remember the case law;
3. Sometimes it’s worth chancing your arm; and
4. If you look hard enough, there are still pockets of common sense to be found.

If we were to compare the developments in UK pensions in 2010 to a football match, it might be described as a classic game of two halves – with the half time whistle being blown a little early in May for the General Election.

Unlike most football games, there was a new coalition referee for the second-half who decided that some of the goals in the first half were under review. If fans were feeling a little cheated at this point, they soon got over it as the second half began with a flurry of events, announcements, consultations, surveys, opinions, discussions, guidance, strikes and so on – I even recall someone saying at a meeting in June that they were unable to offer an opinion on the market because they had been on holiday for a week.

With so much having happened in 2010, and as we begin the countdown to Christmas and the New Year, we thought it might be useful to look back, sort the fact from the fiction and offer a post match summary of what actually happened.

Please let us know if we have missed anything out, what’s affected you most or what is likely to go down as the big story of 2010 in years to come – there’s plenty to choose from.

A new Government
In the first four months of the year, under Gordon Brown’s leadership, the DWP published regulations for Automatic Enrolment and National Employment Savings Trust (NEST) and confirmed that the option to contract out of the additional State Pension into a Defined Contribution pension scheme would be abolished from 6 April 2012.

But did it all matter when, after 6 days of uncomfortable behind-the-scenes negotiations, the Labour Government was replaced by the newly formed Conservative and Lib Deb Coalition on 12th May.

With the new government came a new lineup under David Cameron: George Osborne as the Chancellor of the Exchequer, Iain Duncan Smith as Secretary of State for Work & Pensions and Steve Webb as Minister for Pensions.

Some strong statements and intentions followed soon afterwards. IDS was first up with his vision for improving the quality of life by phasing out the default retirement age, ending compulsory annuitisation at age 75 and, from April 2011, the Basic State Pension was to rise by the minimum of prices, earnings or 2.5%, whichever is higher. He also committed to making automatic enrolment and increased pension saving a reality.

Next it was George Osborne with the first Budget of the Coalition Government on 22nd June, which included a number of announcements on pensions:

• Pensions Indexation. From April 2011, the Consumer Prices Index (CPI) will be used for the indexation of all benefits, tax credits and public service pensions.
• State Pensions and Benefits. From April 2011, the basic State Pension will be uprated by the higher of earnings, prices or 2.5 per cent. CPI will be used as the measure of prices but the basic State Pension will be uprated by the equivalent of RPI in April 2011.
• State Pension Age. The Government will review the date at which the State Pension Age rises to 66.
• Pensions Tax Relief. The Government will restrict pensions tax relief through an approach involving reform of existing allowances, principally of a significantly reduced annual allowance in the range of £30,000 to £45,000.
• Public Service Pensions. An independent commission chaired by John Hutton, formerly Secretary of State for Work and Pensions, will undertake a fundamental structural review of public service pension provision by Budget 2011.
• Default Retirement Age. The Government will consult shortly on how it will quickly phase out the Default Retirement Age from April 2011.

Two days later, reviews were announced into the timing of the State Pension Age rise to 66 and how best to implement auto-enrolment.

We all caught our breath for a few months and then, in October, the Government announced that, from April 2011, the annual allowance for tax privileged pension saving will be £50,000 and from April 2012 the lifetime allowance will be £1.5million.

Soon after, the outcome of the independent review into auto-enrolment was published and, separately, the Government announced that the State Pension age would rise from 65 to 66 between December 2018 and April 2020 for both men and women.

The Pensions Regulator flexes its muscles
Bill Galvin became the new chief executive of tPR from 17 May, replacing Tony Hobman, after five years in charge.

Soon after, guidance was issued on record keeping, monitoring employer support, multi-employer schemes and winding-up. Consultations were launched on transfer incentives and single equality schemes.

From June to September tPR used its powers of enforcement, handing out the first Contribution Notice to the Bonas Group Pension Scheme and a Financial Support Direction to companies connected with the Nortel Group and Lehman Brothers Group.

After four years of operating the Trustee Register, tPR changed the way it assesses the conditions for registration. From 51 firms at the start of the year, it is expected that this number will be considerably less by the year-end.

and the PPF was busy too
January and November saw the PPF unveil not one but two Purple books as a revamp took place and those schemes currently in the assessment period were removed.

June was the month the PPF issued new guidance to actuaries completing section 143 valuations and in October a new formula was proposed for calculating the pension protection levy from 2012/13 onwards.

Finally, as the year approached its end, the first scheme (the Paterson Printing Pension Scheme) successfully transferred through the new Assess & Pay Programme, just under 18 months after the company went insolvent.

How 2010 is shaping up – end of year financials
As we write, the pound is up 4.5% in the year against the Euro and down 3.5% against the dollar, the FTSE 100 sits around the 5750 mark, up 6% on the year, and the benchmark government bond yield has hardly moved compared to a year ago. Wouldn’t it be great if these relatively moderate movements were the result of a number of small predictable steps in one direction throughout the year and we knew what was going to happen next year? If only it was that easy when we agreed our recovery plans.

No doubt many of us will end the year by looking to the future. Will 2011 be the year that EU regulation imposes further funding requirements on defined benefit schemes? How will the rpi/cpi debate play out? Will new rules allow early access to 25% of our pensions savings if we fall ill? How about an ETV mis-selling scandal? Like 2010, a lot could happen. Please let us know what your predictions and concerns might be.

But before you become too paralysed with fear about potential hyper-inflation, the break-up of the European Union, winning the Ashes or never hosting the World Cup, you may wish to consider the words of Mark Twain: “I’ve been through some terrible things in my life, some of which actually happened”.

With Seasonal Best Wishes,
Brian Spence and the team at Spence & Partners

Apparently the Baiji (Yangtze River Dolphin) is amongst the rarest mammals in the world. It may even be extinct. Clearly there’s a fine line between being very, very rare (i.e. only one left) or being extinct (none left). The last definitive sighting was in 2004. It was declared functionally extinct in 2006 but video footage of what might have been a Baiji was taken in 2007 raising the possibility that there was at least one survivor out there, wisely staying well clear of humans.

When it comes to pensions legislation common sense is nearly as uncommon, but we appear to have a confirmed sighting in the DWP’s response to the consultation on the abolition of contracting out on a defined contribution basis.

Now I have never understood why one of Margaret Thatcher’s most lauded sound bites was “You turn if you want to. The lady’s not for turning!” Not turning in the face of irrefutable danger or logic is not a particularly common sense position to adopt. Indeed history and experience teach us that a U turn is not necessarily a wrong turn.

If only the Titanic had been able to perform a timely U turn. Or Thelma. Or Louise.

So clearly I welcome the Government’s common sense U turn on the abolition of transfers from contracted out pension schemes. I had blogged previously about the iniquities of the original provision, sneakily hidden in the regulations regarding the abolition of DC Contracting-out, which could have outlawed such transfers. Respondents to the DWP’s consultation on these Regulations presented a factual and rational analysis as to why, for some people, based on their particular circumstances, transferring out of a contracted out defined benefit scheme is clearly in their interests. A lesson that the Pensions Regulator could usefully learn.  More importantly the DWP appears to accept that the decision about whether or not to transfer should be made by the member, having taken impartial advice, rather than be imposed in some crass one size fits all, we know what’s best for you, diktat from the nanny state.

As I previously noted the draft regulations did rather smack of an admission that the FSA was failing in its duty to regulate this particular area of advice. Rather than address that shortcoming they have tried to foist the responsibility for regulation of transfers onto pension scheme trustees through the Pension Regulator’s “guidance” framework. Some commentators had responded to this development by suggesting that it was wrong and possibly illegal for trustees to fully embrace the Pensions Regulator’s guidance on enhanced transfer value exercises. Given this, abolition may have seemed like an easy option, despite its inherent unfairness.

Yes members need protection from unscrupulous advisers but that is why we have the FSA and, from 2013, the Consumer Protection and Markets Authority. It is certainly not why we have pension scheme trustees, who have a difficult enough job to do without being forced to do the regulators’ jobs for them.

We have consistently argued that properly structured and funded enhanced transfer value exercises are a legitimate approach for employers to engage with their scheme members with a view to managing their liabilities. They also provide members with an opportunity to properly review their retirement planning with a professional adviser.

So credit where credit’s due, well done to the DWP for changing its mind on this one. It will be interesting to see if the Pension Regulator’s finalised guidance on enhanced transfer exercises will also be leavened with common sense.

Now if the DWP could only be persuaded to approach the question of GMPs in the same manner as it has recently dealt with Protected Rights – that is, just make them disappear – then that would be further evidence that, after years of languishing in neglect, common sense is unexpectedly back in vogue at Westminster.

I read with interest the guidance to individuals with money purchase benefits published on 2 November by the Pensions Regulator (tPR) and echo comments from Pensions Minister Steve Webb that “choices we make at retirement are amongst the most important of our lives” and “shopping around can provide better value for money and significantly boost retirement income”, and those from tPR’s acting Chief Executive Bill Galvin who has stated that “members could miss out on a higher retirement income because they are not well-supported in making good choices”.

The engagement of the Pensions Regulator in the education process within occupational defined contribution schemes is welcome, and emphasis has rightly been given to the potential benefits to members of obtaining independent financial advice. In particular, the guidance should act as a reminder to Trustees of schemes which provide both defined benefits and money purchase benefits that the members with money purchase benefits deserve due care and attention.

However, the guidance appears to be in stark contrast to the regulatory approach and pending legislation governing defined benefit arrangements, particularly those containing contracted-out rights. The “presumption of guilt” surrounding transferring benefits out of a defined benefit arrangement, and the potential end to the ability to transfer contracted out rights from defined benefit to money purchase arrangements in 2012, would seem to be at odds with the ethos of encouraging members to make choices which best suit their own circumstances.

For example, the value contained in some defined benefits (such as a prescribed level of pension increases or spouse’s pensions where the member is single or where the spouse already has a substantial pension), could be used to provide alternative benefits which are more suited to the needs of the individual concerned. Also the value of a money purchase pension pot can be retained on the death of the member, whereas this event may cause the value of a defined benefit to be significantly eroded .

I would therefore ask that members of defined benefit arrangements continue to be afforded the same opportunities to exercise their “Open Market Option” in the future.

Recent government announcements are likely to have a significant financial impact on pension scheme funding, the actuarial assumptions used, commutation factors and early or late retirement.

In June’s budget the government announced that it intended for future increases in public sector pensions to be linked to changes in the Consumer Prices Index (CPI). Historically such pensions were linked to increases in the Retail Prices Index (RPI).

A subsequent statement by the Pensions Minister on the 8th July confirmed that the government also intends to use CPI for determining statutory minimum increases which apply to private sector pensions. Read more »

It has seemed obvious to us for many years that trustees and actuaries would eventually be required to end inequality within occupational pension schemes resulting from guaranteed minimum pensions (GMPs) accrued since 17 May 1990.

The Government’s statement by Angela Eagle on Thursday 28th January is an extremely welcome and sensible step. There is undoubtedly some detail to work through for individual schemes but at least now hopefully the industry can get on with it.

Spence & Partners have extensive experience as actuaries and as independent trustees of implementing practical methods of equalising GMPs.

Stand back though for the roars of anguish from the industry!

Brian Spence is a founder of actuaries Spence & Partners Limited and a director of independent trustee Dalriada Trustees Limited.  You can follow him at @briandspence or @PensionsEndgame on Twitter or link to him on LinkedIn.  Dalriada provides professional trustee services and Spence & Partners can provide support to employers in appointing an independent trustee.  Brian has written a series of articles on appointing an independent trustee.

Follow @SpencePartners and @DalriadaTrustee on Twitter.

Another change in administration procedures coming up soon!
Earlier in the year the Registered Pension Schemes (Authorised Payments) Regulations 2009  came into force, forgiving the tax penalty on certain payments which were previously deemed unauthorised, e.g. payments made in error and payments of arrears of pension due after the death of a member.
From 1 December 2009 these regulations allow occupational pension schemes to commute trivial pensions, in certain circumstances, without any reference to the benefits a member may have in other unrelated pension schemes or contracts. This will be limited to pensions with a capital value of less than £2,000. The usual taxation procedures will apply.
Unfortunately these regulations do not apply to individual insured arrangements so sadly another blow to the ‘one size fits all’ regime affectionately known as Pensions Simplification!