Falling inflation could cost schemes £5 billion

August, 2020 Print

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A prospective fall in inflation below zero could place an additional £5 billion in funding pressure on schemes, according to analysis by consultancy LCP.

The firm has modelled the likely level of inflation over the coming months based on three economic scenarios – whether the economy is “stuck in the doldrums”, “steady as she goes” or enjoying a “bounce back”.

LCP found that consumer prices index inflation could be negative in September and could even be as low as -2.8%.

Negative inflation creates a ratchet effect for pension increases that in turn means that in the medium term pensions can now be expected to increase by more than inflation, which is a higher cost than has been budgeted by schemes, the consultancy said.

LCP forecast RPI to be -0.8% under a “steady as she goes” recovery scenario. With around £800 billion in index-linked DB benefits in payment in occupational pension schemes, a 0.8% increase in the real cost of benefits could represent a hit of more than £5 billion on schemes.

CPI inflation had already fallen sharply from 1.5% in the year to March 2020 to 0.8% in April 2020 and 0.5% in May.

Jonathan Camfield, partner at LCP, said that ultra-low interest rates and market volatility had already weakened the funding position of many schemes, but negative inflation could add a further financial burden.

“Schemes generally cannot reduce pensions in payment even when prices are falling, resulting in a real-terms increase in the cost of providing pensions,” he said. “We anticipate that this could add at least £5 billion to long-term scheme costs and the burden on their sponsoring employers as deflation is expected to be experienced in the economy over the coming months.”

The impact on individual schemes will depend on factors such as the extent to which indexation of pensions in payment is linked to inflation, the reference month within the scheme’s rules that is used to assess pension increases, and the approach taken to hedging the pension increases, LCP said.

 

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