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How inflation impacts pensions

by LLB Reporter
18th Aug 22 11:03 am

Soaring inflation affects everyone, including those in receipt of a pension income. Not all pensions are made equal, however, with some – most notably public sector pensions – benefitting from generous and uncapped inflation protection.

State pensions are also set to rise substantially next year, with all eyes on September’s inflation figure, which is traditionally used to uprate benefits the following year. If by that time inflation has reached the Bank of England’s forecast 13%, the new state pension would breach £200 a week for the first time, with the Exchequer wearing an estimated £13 billion bill.

Here Tom Selby, AJ Bell head of retirement policy, assesses what rising prices could mean for people with different types of pension and what it means for retired people facing a cost-of-living crisis:

  • Drawdown – don’t stick your head in the sand

“Anyone in drawdown needs to think carefully about how they respond to rising prices. The good news is that you’re in complete control, thanks to flexible pension reforms that allow savers to choose exactly how they use their pension.

“However, that also means it is up to you to ensure those savings last throughout your retirement. The natural thing to do in response to rising living costs might be to take more income from your pot to maintain your standard of living, but this increases the risk of your fund running out early.

“This risk will be further exacerbated if larger withdrawals are combined with substantial market falls – something many have already experienced in 2022.

“This isn’t a reason to panic, but retirement investors must not stick their heads in the sand either. Think carefully before increasing your withdrawals and make sure you have considered the impact that decision could have, ideally with the help of a financial adviser.

“AJ Bell customer research suggests investors are taking a mixed approach, with the majority (60%) keeping withdrawals the same, while 24% are cutting back withdrawals in the face of market uncertainty and 16% are increasing withdrawals. All of these actions may be perfectly sensible depending on the person’s circumstances.”

  • State pension – Could exceed £200 a week from next April

“The ‘basic’ state pension and the ‘new’ state pension both benefit from the triple-lock guarantee, meaning they increase by the highest of average earnings, inflation or 2.5%. The inflation part of the triple-lock will almost certainly apply for the 2023 increase, assuming the triple-lock is retained. The now former Chancellor, Rishi Sunak, temporarily suspended the triple-lock due to an unforeseen year-on-year spike in wage growth in 2021 after the pandemic supressed wages in 2020.

“Nonetheless, it would be extremely divisive to break the triple-lock pledge again on the basis of an unexpected rise in inflation – particularly with a general election on the horizon.

“Currently, the basic state pension is worth £141.85 per week (£7,376.20 per year), while the new state pension pays £185.15 per week (£9,627.80 per year).

“If inflation in September hits 13%, this implies the basic state pension would rise by £18.45 to £160.30 per week (£8,335.60 per year), while the new state pension would rise by £24.10 to £209.25 per week (£10,881 per year).

“Other pensioner-related benefits – such as additional state pension (which applies to state pensions for those who reached state pension age before April 2016) and Pension Credit – and working-age benefits also usually rise in line with September’s inflation figure.

“The cost of increasing the state pension by 13% would be astronomical, with each 1 percentage point rise costing roughly £1bn. And that is not a one-off cost either. The inflationary increases are baked-in so state pension costs will be significantly more expensive going forward.”

  • Annuities – majority are not inflation linked

“Annuities lock in a retirement income for life. This provides extra certainty but limits flexibility and extinguishes the possibility of generating further investment growth.

“The impact of high inflation on those who have already bought annuities will depend on the type of annuity bought. Some will have inflation protection baked into the terms of the contract, although this is often capped. If inflation exceeds the cap – which it will for many people this year – then your income is actually falling in real terms. This will no doubt anger people that purchased what they hoped would be an inflation-proofed income.

“However, most people (historically at least) have bought annuities with no inflation protection, meaning they risk being brutally exposed to surging prices.

“In the 2020/21 tax year around 85% of the 60,000 annuities purchased were ‘level-only’, meaning they had no inflation protection at all. Just 15% of annuities bought were ‘escalating’, meaning they rise with inflation.”

  • Public sector pensions – Inflation protection guaranteed

“Defined benefit (DB) pensions provide a guaranteed income for life similar to annuities, except this time the promise is underwritten by the employer. In the case of public sector pensions, that employer is the state, meaning pensions are essentially underwritten by taxpayers.

“It means former public sector employees can expect to see their pension income rise by as much as 13% next year, depending on September’s inflation figure.

“There is a broad cost control mechanism that could see public sector pensions tightened in other areas – for example by raising retirement age or increasing contribution rates – in order to avoid the burden on taxpayers spiralling completely out of control.”

  • Private sector defined benefit pensions – capped increases

“The impact of inflation on private sector DB pensions will depend on the rules underpinning the scheme. Often these rules will place a cap on inflation protection, meaning they won’t enjoy the same increases as their peers that worked in the public sector.

“This pension apartheid will rankle former private sector workers that see their spending power diminished.

“Some schemes still use RPI as the measure of inflation against which to uprate pension payments. As things stand RPI is a whopping 12.3%, and typically runs higher than CPI. It could have meant private sector DB scheme members received an incredible CPI-busting increase, but that will be quashed if schemes apply the 5% and 2.5% caps available to them.

“UK plc will no doubt be grateful for the option to apply a cap, since firms with a liability to former employees could otherwise face needing to top-up their pension scheme, potentially hindering investment in the business”

  • The Pension Protection Fund – 2.5% inflation rise

“When private sector DB schemes go bust, the Pension Protection Fund (PPF) is responsible for paying out members’ pensions. If the UK enters recession, it is likely more schemes and their members will join the PPF if the parent company is forced under.

“The inflation protection you might from receive from the PPF varies depending on the period of time during which you built up the benefits.

“In most cases payments relating to pensionable service from 6 April 1997 onward will rise in line with inflation each year, but subject to a cap of 2.5% a year. At current inflation rates that means PPF members will be experiencing significant real terms cuts in their benefits.”

  • Lifetime allowance – remains frozen despite soaring inflation

“The lifetime allowance was supposed to rise in line with CPI inflation but the Government cancelled these increased until 2025/26. As a result, the lifetime allowance will remain frozen at £1,073,100 for the rest of this Parliament.

“All other pension tax allowances – including the annual allowance, money purchase annual allowance (MPAA) and tapered annual allowance – do not increase in line with inflation.”

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