Granting inflation-driven discretionary increases could add £8bn to liabilities across private sector defined benefit (DB) schemes, according to analysis from Aon, which has raised concerns over the "difficult decisions" facing trustees in this area.

The firm explained that whilst most schemes have pension increases with caps, with many capped at 5 per cent per annum, if, as expected, inflation is above 5 per cent in September, schemes will need to consider the impact of discretionary increases.

In particular, Aon emphasised the need to clarify who has the discretion in scheme rules to decide whether or not to provide increases above the cap, with Aon partner, Lynda Whitney, warning that a "potentially tricky situation is looming".

"Is the discretionary increase power with the trustees, the sponsor or a combination of the two?" she queried, suggesting that even if either party has unilateral power, reaching a consensus will often be desirable.

“It’s possible that some schemes could justify that they have been receiving significant deficit contributions to meet the guaranteed benefits and do not see the current scenario as a reason to provide a benefit improvement," Whitney added.

However, Aon pointed out that whilst schemes’ technical provisions deficits are much lower than the last time the Retail Prices Index (RPI) was over 5 per cent in 2011, there are other notable differences that could also impact this decision.

Most DB schemes, for instance, are now trying to head for long-term targets, which Aon suggested could be limited by granting discretionary increases, while schemes’ inflation hedging levels are also now much higher.

However, Whitney suggested that whilst it may be "logical" for schemes not to pay the benefit improvement of discretionary pension increases and to progress faster on the journey to their long-term target, there could be much more public demand now for discretionary pension increases than there was in 2011.

Indeed, Aon stated that inflation was not a factor that was high in the public conscious in 2011, unlike the current circumstances, where some of the causes of inflation, such as the cost of energy, are set to hit pensioners particularly hard.

Public expectations may also be skewed by the triple lock promise around the state pension, which does not have a cap, as Aon suggested that this could also drive pensioners' expectations for pension increases elsewhere.

"We are currently navigating new forms of volatility and with a different economic landscape in 2022, there is much more public awareness of high inflation," Whitney stated.

She continued: “For members with elements of pension that receive no guaranteed increases - for example, those with only discretionary increases on pre-1997 accrued benefits - the impact of inflation eroding the benefit will be even more significant.

"For example, with inflation at 2.5 per cent a year, the buying power of this type of pension will halve in 28 years; with inflation at 5 per cent a year, it will halve in 14 years; at 7.5 per cent a year, it would halve in just nine years.

"But this is a feature of the benefit design and does not necessarily imply that it is a pension scheme’s responsibility to help manage it.

“Overall, trustees and sponsors will need to look at their complete long-term funding plan and understand how guaranteed and discretionary pension increases fit within it and make decisions accordingly.

"But they may also need to be ready to explain to members how they have reached their decision on whether or not to grant a discretionary pension increase.”

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