12 million face pension cuts

As public and private sector final sector pension benefits are set to be reduced, how will you be affected?

Last June I wrote No hope for final salary pensions as the National Association of Pension Funds (NAPF) predicted that 1,000 schemes would bite the dust directly as a result of the economic crisis.

Since then matters have failed to improve as 94% of the UK’s leading employers say they intend to cut benefits or axe their final salary scheme, according to a recent survey from business advisors, PriceWaterhouseCoopers.

In the meantime, many schemes continue to limp on with growing deficits. This is causing huge concerns for employers who offer private sector plans and the government in relation to public sector pensions.

Final salary schemes are hugely beneficial since they offer workers a guaranteed income in retirement. But the government and employers bear all the liability in meeting that promise with no risk to the employee whatsoever.

Not surprisingly pensions which provide guaranteed benefits are incredibly expensive to run. And recently it became clear that, one day soon, it was all going to have to change.

Changes to final salary pension schemes

The emergency Budget on June 22 unveiled a range of dramatic changes to the UK pensions regime, most notably cuts to the State pension and public sector pensions schemes. Back then the Chancellor announced annual increases in such schemes would be linked to the CPI (Consumer Prices Index) from next April, rather than the RPI (Retail Prices Index).

The income paid from the State pension will increase according to a ‘triple guarantee’ which means it will be uprated annually by the higher of the rise in the CPI, average earnings or 2.5%. Meanwhile, public sector final salary schemes will be uprated by the rise in the CPI.

Why is this bad news?

Quite simply, the CPI normally steps up at a slower pace than the RPI which can only mean increases in the income paid year on year from final salary schemes will rise more slowly than it would have done had the link to the RPI remained in place.

This is because the CPI excludes mortgage interest costs generally making it a lower measure of inflation than the RPI.

That said, there have been one or two occasions where the rise in the CPI was actually greater than the RPI. But, most of the time, the CPI is lower. At the last count, for example, the rise in the CPI was 3.2%, while the RPI stood at 5%.  

The government has decided the CPI is a more appropriate measure since most pensioners are mortgage-free. But given that inflation for the items which take up a higher proportion of pensioner income - such as council tax, food and fuel - is way beyond the CPI, this isn’t an entirely convincing reason for switching the inflation measure used for uprating pensions.

Bad news for the private sector

But there’s more bad news for workers as the government has just announced that uprating pensions by the CPI, in the place of the RPI, will apply to private sector final salary schemes as well as public sector pensions from next April. This move means 12 million people in the UK now face pension cuts.

This change also applies to preserved pensions which will also be revalued in line with the CPI once a member has switched employment and left the scheme.

How much could you lose?

According to figures from IFA firm Hargreaves Lansdown, a pensioner retiring now with an income of £5,000 from a final salary scheme could expect an income of £9,737 in 20 years’ time if it was uprated by the rise in the RPI.

However, if the income was instead linked to the CPI, it would be worth just £8,497 over the same period, which means a loss of 13%. This is equivalent to a total loss of £10,367 over 20 years.

People with preserved pensions will feel the effects of the cuts even more keenly. Not only will their pensions be uprated annually by the CPI, which is anticipated to be lower than the RPI measure, but they will also rise by the lower CPI figure when benefits are taken in retirement. This double whammy of reductions will likely have a dramatic effect on pension income in the future.

Hargreaves Lansdown estimate that someone aged 40 with a preserved pension worth £5,000 could receive a pension of £11,603 by the time they come to retire at 65 if it was linked to the RPI. But increasing the pension by the CPI each year instead, could result in a far lower income of £9,769.

(Note these figures are based on historical values for the CPI and the RPI.)

Will the changes save final salary schemes?

There’s no question final salary pension schemes are hugely beneficial to public and private sector employees alike. And even in this diluted form they are still superior compared with defined contribution schemes.

Defined contribution schemes - like ordinary personal pensions - don’t provide any guaranteed benefits, and instead usually rely on stock market performance to provide a large enough pension pot to convert into a decent income in retirement. Of course, if stock market returns aren’t good, pension income will be depressed.

So it’s still in members’ best interests to hold onto their final salary schemes even if it's likely they will be uprated more slowly than they would have been. The changes should alleviate some of the liability on employers, but whether it’s sufficient to dissuade the 30% of companies PriceWaterhouseCoopers has indentified who plan to close their scheme to existing staff, only time will tell.

If you will be affected by these cuts, think seriously now about how you will make up a possible shortfall in your pension income as a result of these changes. It may be necessary to make extra provision of your own to ensure you don’t lose out further down the line.

More: Help! In my forties and still no pension | The terrible news for your pension