The government has proposed introducing ‘conditional indexation’ for defined benefit pension schemes so an employer could suspend increases to pension payments if it was in a stressed financial position.

The suggestion was made in a government green paper entitled Security and Sustainability in Defined Benefit Pension Schemes which has been launched following high profile cases involving the DB schemes of BHS, Bernard Matthews and Tata Steel.

The proposal would mean that no increases would be paid if the scheme was in deficit and the sponsor was unable to make up the deficit, and the trustees were satisfied that the best interests of members would be served by suspending indexation to allow the employer to strengthen its corporate finances. The government noted that increases could be recommenced in the future, once the employer had recovered.

Despite the proposal, it was noted that there is a “moral hazard issue” as there is a danger that it could encourage employers to allow the funding level of their scheme to deteriorate in the hope that it would reduce their liability to inflation link the scheme benefits.

“Therefore, requirements that the sponsor funds the scheme to a high level and limits risk when ‘times are good’ may be needed in conjunction with allowing relaxations in times of stress,” the paper stated.

Currently, for pensions accrued between 1997 and 2005 there must be an annual increase of inflation capped at 5 per cent, and for pensions accrued after 2005, inflation capped at 2.5 per cent. Pensions accrued before April 1997 do not have to be increased unless scheme rules require it – although any Guaranteed Minimum Pensions accrued from April 1988 do have to be indexed by inflation capped at 3 per cent, which can complicate the issue in practice.

The government does not, however, specify which index inflation increases should be linked to, and for public sector pensions it switched from the Retail Price Index to the Consumer Price Index in 2010. However, some schemes which have a specific index, 75 per cent with RPI, written into their scheme bill have not been able to change which one they use.

For example, in the case of Tata Steel there was a suggestion that the scheme could be saved by switching the indexation of pension payments from the RPI to the CPI, but for them it would have required a change in the law.

However, in the green paper, the government said allowing schemes to switch to CPI from RPI would have a “significant impact on members’ benefits”. CPI has been lower than RPI in 22 years out of the last 27 years (and in 9 years, out of the last 10 years) up to 2015, and so would in all likelihood represent a reduction in members’ benefits.

It referenced estimates from Hymans Robertson that show a move from RPI to CPI would take away around £20,000 in benefits over an average DB scheme member’s life.

Furthermore, the government raised concerns that such a move would also affect the government’s ability to issue debt in a cost-effective way. This is because it would also likely have significant interactions with the gilt market and wider government financing objectives. Currently, index-linked gilts (ILGs) are linked to RPI, as this was the standard measure of inflation when ILGs were introduced and pension funds hold nearly 23 per cent of their assets in ILGs. Therefore, any changes to scheme indexation could have significant consequential effects on the price of these gilts.

However, it noted that Pensions and Lifetime Savings (PLSA) DB Task Force research found that “increasing pensions by a lower level of inflation was seen to be the most palatable benefit adjustment if one had to be made”.

"Introducing a statutory over-ride to allow schemes to switch from RPI to CPI could amount to a saving to sponsors and lower future pension increases for members amounting to £90bn as discussed previously. However, the changes would impact schemes differently, where the largest schemes would experience the largest monetary savings, and not all schemes would see a benefit from such an easement, but some members pensions would be significantly lower."

The consultation is open until 14 May 2017 and can be viewed here.

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