July 9, 2010 7:02 pm

CPI blow to final-salary plans

Up to 12m members of final-salary pension schemes face the prospect of a smaller pension, following the government decision to increase payments in line with the consumer price index (CPI) rather than the retail price index (RPI) – and advisers now warn that many will need to make extra savings.

This week, Steve Webb, pensions minister, announced that the switch from RPI to CPI index linking for public-sector pensions – as signalled in last month’s emergency Budget – would also be applied to private-sector pensions.

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At present, final-salary schemes are required to increase the pensions they pay in retirement and the “deferred” pension entitlements of former employees by at least RPI or 2.5 per cent, whichever is the lower. In the past 20 years, RPI has averaged 3.6 per cent. However, the new rules will see the minimum increase change to CPI, which has historically lagged RPI as it does not include housing costs such as council tax. In the past 20 years, CPI has averaged 2.8 per cent.

Private-sector schemes are allowed to uprate pensions by more than this minimum amount, and the National Association of Pension Funds said some might choose to go on using RPI if it is higher. But pension experts warned that most will use CPI to reduce their scheme liabilities. Most trustees will revert to the statutory minimum, as they can base their future liabilities on CPI,” said John Lawson, head of pensions policy at Standard Life.

Independent advice firm Hargreaves Lansdown has calculated that this change can reduce a pension up to 15 per cent. Based on average rates of RPI and CPI, a 40-year-old with a £5,000 preserved final-salary pension today could have expected to receive a pension of £11,603 from age 65 if uprated in line with RPI – but this falls to £9,769 with CPI uprating.

Advisers said scheme members might need to make additional savings in tax-efficient schemes. “Consider saving some of your income into an Isa in order to build up a buffer that can be dipped into if your pension income starts to substantially lose its buying power,” said Laith Khalaf of Hargreaves Lansdown.

Lawson of Standard Life suggested using other funds to buy extra annuities in retirement. “Save a bit more and give yourselves some flexibility to top up your pension,” he advised. “Buy an additional annuity at 70 or 75 should indexation of your pension not keep pace with your inflation.” Finding an RPI-linked annuity in future might prove difficult, though. “We may well see insurers offering CPI-linked individual annuities,” said Khalaf – although he added that these would provide a higher starting income to retirees.

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