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Defined Benefit (DB) pension schemes provide pension benefits based on salary and length of service. There are statutory minimum requirements on them to:

  • Index pensions in payment in line with inflation, capped at 5% for benefits accruing from service between April 1997 and April 2005, and at 2.5% for benefits accruing from April 2005 – known as Limited Price Indexation (LPI) (Pensions Act 1995, s51);
  • Revalue the deferred pensions of early leavers in line with inflation capped at 5%, and at 2.5% for rights accrued on or after 6 April 2009 (Pension Schemes Act 1993).

Before April 1997 there was no general obligation on DB schemes to increase pensions in payment (although there was a requirement on schemes that were contracted out of SERPS to provide indexation capped at 3% on rights accrued from 1988) – see Guaranteed Minimum Pension (GMP) Increases, Commons Library Briefing Paper, CBP 4956, Feb 2020.

Importantly, these are statutory minimum requirements -there is nothing to prevent schemes from making more generous arrangements through their scheme rules (HC Deb, 19 July 2010, c4).  Despite the fact that indexation was not made mandatory for rights accrued before 1997, it appears that many schemes did apply some form of inflation protection to pensions in payment on a voluntary basis and many applied LPI retrospectively to service before 1997 (Deregulatory Review, March 2007)

Members of some occupational pension schemes – such as the Hewlett Packard Pension Association – have called on the Government to require indexation of pre-1997 rights. However, the Government has has no plans to do this, on the basis that it would mean “significant additional expenditure for any scheme and its sponsoring employer” – see Library Debate Pack CDP- 2017-0016, September 2017.

Development of limited price indexation

In 1993, the Pension Law Review Committee, chaired by Professor Roy Goode, recognised the importance of indexation from the individual’s perspective:

  • Most important is the uncertainty with regard to inflation. The individual is concerned not with money amounts but with what the pension will buy. (Pension Law Reform. The report of the Pension Law Review Committee, para 3.1.10)

Despite this, the Committee did not recommend making indexation requirements retrospective, because it:

  • […] recognised that to require all earnings-related schemes to introduce LPI for pension rights accrued before the appointed date would place a considerable burden of costs on such schemes. (Ibid)

Limited Price Indexation (LPI) – a requirement to index pensions in payment in line with inflation capped at 5% – was introduced under the Pensions Act 1995 (s51).

The Labour Government legislated to reduce the LPI cap to 2.5% for rights accrued from April 2005 in the Pensions Act 2004 (s278-9). Following consultation, it had decided that “mandating some level of protection from inflation remains desirable” but that lower inflation levels made a reduction in the cap appropriate (Cm 5835, p23).

In December 2006, an independent review looked at whether LPI should be removed. However, the reviewers – representing the employer and union sides – were unable to agree. The Labour Government decided not to remove the requirement on the grounds that it was an important protection for members and there was no clear evidence that removing it would have a direct and significant effect on employer provision (Government response to Deregulatory Review, October 2007, p6).

Switch to the CPI

From April 2011, the Coalition Government changed the measure of inflation used for determining the annual minimum increases from the Retail Price Index (RPI) to the Consumer Prices Index (CPI) (HC Deb, 8 July 2010, c14-16 WS).The change was controversial because the CPI inflation tends to be lower than RPI inflation. The impact of the legislative change on individual schemes would depend on what their rules said (DWP, Impact assessment, 12 July 2011).

The Government considered introducing a ‘statutory override’ to allow schemes to change their rules where they might otherwise be prevented from doing so. (DWP, The impact of using CPI etcconsultation on Government proposals, December 2010). However, it decided against on grounds that trust in pensions was important and that government justification demanded strong justification. Where a scheme did intend to change its rules for future accruals, employers would be required to consult (Government response to consultation, June 2011, para 18 and 34).

Whether there should be flexibility

In its December 2016 report on Defined Benefit pension schemes, the Work and Pensions Select Committee said schemes that had latitude in their rules to switch to the CPI had tended to do so. It recommended that the Government consult on “permitting trustees to propose changes to scheme indexation rules in the interests of members”:

  • Pension promises are just that. Any change to the terms of them should not be taken lightly. In circumstances where an adjustment to the scheme rules would make the scheme substantially more sustainable, however, a reduction in benefits could well be in the interests of members (para 110-11).

In its February 2017 Green Paper, the Government asked for views on whether:

  • There was evidence to suggest an affordability crisis that would warrant permitting schemes to reduce indexation to the statutory minimum;
  • The Government should consider a statutory over-ride to allow schemes to move to a different index, provided protection against inflation was maintained;
  • The Government should consider allowing schemes to suspend indexation in some circumstances. (DWP, Security and Sustainability in Defined Benefit Pension Schemes, CM 9412, Feb 2017).

The March 2018 White Paper ruled out changes to override scheme rules:

  1. We are committed to protecting members’ pension benefits, and are presently ruling out measures which would override provisions in scheme rules and allow employers, or schemes, to change the measure of inflation used to calculate annual increases. However, we will continue to monitor developments in the use of inflation indices. (Cm 9591, March 2018).

Reform of the Retail Prices Index (RPI)

The RPI was acknowledged to be a flawed measure by the UK Statistics Authority (UKSA) in 2013. In 2019, a House of Lords Committee recommended that it should be reformed to prevent ‘inflation measure shopping’ by the Government. In a statement on the future of the RPI in September 2019, UKSA said it intended to address the shortcomings of the RPI by bringing into it the methods of CPIH (Consumer Price Inflation including owner occupier housing costs). Until 2030, it requires consent of the Government to do this. In March 2020, UKSA and HM Treasury launched a consultation on the impact of the reform and when it should take place, between 2025 and 2030.

The HM Treasury/UKSA response to the consultation in November acknowledged that there would be an impact on DB pension schemes and members. For scheme members with RPI-linked benefits, the reform would result in a reduction in the lifetime benefits (para 95-7). For schemes, the impact would depend on the extent to which their investments and pension benefits were linked to the RPI. DB schemes with CPI-linked pensions hedged with RPI-linked assets see a negative impact on their funding position other things being equal because the total value of their assets would fall without a corresponding fall in liabilities (paras 65-76). Chancellor of the Exchequer, Rishi Sunak, said he could see the statistical arguments for UKSA’s proposed approach. To minimise the impact on the holders of index-linked gilts, the reform would not be implemented before 2030. The Government would not offer compensation to holders of index-linked gilts. It would keep the occupational pension system under review (para 19-20; PQ 126013, 7 December 2020).

The Pensions and Lifetime Savings Association expressed its disappointment that the Government had “chosen to disregard the detrimental impact this move will have on both savers’ retirement incomes and on the assets of UK pension schemes.” It would continue to press its case for solutions to mitigate the impact of the reform.

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