Index link switch puts pensions in limbo

BT has long been emblematic of the woes of the UK’s occupational pension scheme sector, with the liabilities it built up as an integral part of the state-owned post office continuing to weigh heavily on its fortunes.

But earlier this month it had some good news to communicate (for shareholders, at least): thanks to a recent government edict to base future cost-of-living increases on the consumer price index (CPI), rather than the generally higher retail price index (RPI), its liabilities would fall by £2.9bn ($4.7bn), slashing its deficit to £5.2bn.

However, opinion is sharply divided as to how widespread such gains may be, while pension scheme trustees have been left with the headache of how to hedge their liabilities when the entire UK marketplace is based on RPI-linked securities.

“Pension schemes are a bit in limbo. Trustees are probably cursing the government for this proposal and their lack of detail,” says John Dewey, member of the multi-asset client solutions team at Black- Rock.

Much of the confusion stems from the fact that many defined benefit pension schemes explicitly link future pension payments to the RPI. As such they may be little affected by the government ruling, unless primary legislation is introduced to override the wording of their title deeds. However, other schemes merely refer to uprating “in line with the statutory minimum”, which will become the CPI from April 2011.

This matters because, over the past 20 years the CPI has, on average, risen 70 basis points less per year than the RPI, according to JPMorgan, due to differences in methodology and the treatment of housing costs. JPMorgan estimates that only 30 per cent of schemes refer to a vague statutory minimum and will thus benefit from the rule change. Similarly, John Ralfe, an independent pensions consultant, believes few large schemes will be affected by this rule change.

In contrast, KPMG estimates that while only 20 per cent of schemes will be able to switch to CPI-linking for both payments to pensioners in retirement and deferred scheme members awaiting retirement (as BT has done), a further 60 per cent will be able to switch for the latter category, but not the former, given differences in

Danny Vassiliades, principal at Punter Southall, paints a similar picture. “For pensions in payment, almost everywhere I have looked firms have written RPI-like increases in their rules. For deferred members, it’s often the statutory minimum,” he says.

Unsurprisingly, these varying insights give rise to differing estimates of the savings the rule change is likely to bring. KPMG estimates the UK’s £1,100bn stockpile of pension scheme liabilities, and aggregate deficit of £200bn, will fall by £45bn.

JPMorgan believes the 30 per cent of schemes that can change will see their liabilities fall by about 10 per cent, or £30bn. However, Jasper Falk, head of the inflation business for JPMorgan in Europe, warns that schemes with an explicit RPI reference could now be forced to uprate pensions in line with the new CPI-based statutory minimum in years where this measure is higher than retail price inflation.

Historic data suggest this occurs one year in five, typically when interest rates are falling, reducing mortgage payments. JPMorgan estimates this wrinkle will actually push up liabilities by £20bn, slashing the net saving to just £10bn.

This in turn has prompted a lively debate as to whether the government will, or indeed can, introduce primary legislation overriding the wording in many scheme deeds, effectively changing pension entitlements retrospectively.

The Department for Work and Pensions told FTfm it “will be consulting on whether there is a case for overriding legislation shortly”.

Mr Ralfe, for one, is convinced this will not happen. “Primary legislation would just get disregarded in the European courts. It has been tested on a number of occasions where governments have tried to override a private sector contract,” says Mr Ralfe, who also questioned what the government would gain politically from this.

Mr Dewey believes the government is “very keen” to avoid this technicality increasing liabilities for some schemes, but says a full statutory override would be “unprecedented in the history of pension scheme legislation and would be fairly unpopular in some quarters”.

However, Mr Falk says doing nothing is not a strategy the government “can take lightly” while Mr Vassiliades believes there is room for a compromise solution.

Mike Smedley, pensions partner at KPMG, believes politicians would have the power to enforce a level playing field across all schemes, rather than a
“lottery” based on specific scheme wording, given that the government could, if
it desired, simply change the way the RPI is

According to Mr Vassiliades, the uncertainty has already resulted in potential buy-outs of pension scheme liabilities by insurers being put on hold, while enhanced transfer value exercises are also being affected by this “planning blight”.

The longer-term worry centres on how pension funds will be able to hedge their exposure to inflation given that the financial system, including the £216bn worth of outstanding index-linked gilts, is based on RPI-linked instruments.

The Debt Management Office (DMO) says it is willing to consult on the question of introducing new instruments, although this is on hold pending greater clarity from the DWP.

“There will be quite a lot of pressure on the DMO
to start issuing CPI bonds,” says Mr Dewey.

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