The sharp rise in interest rates that we’ve seen over the past few months is obviously bad news for borrowers, especially young people trying to buy their first home.
Rising long-term interest rates have weighed on bond values and the value of defined-contribution (DC) pension pots despite gains in stocks.
However, it’s not all bad news, especially for older Brits. For those with DC pensions who are retired or close to retirement, higher bond rates are great because they lower the cost of buying an annuity (a guaranteed lifetime pension that can be indexed to inflation).
Annuities that can now be purchased with the DC Pension Pot are increased by half in the past 18 months.
For the first time in a long time, an annuity looks “more valuable” than keeping your DC savings and withdrawing monthly, but there’s no guaranteed amount, and no guarantee you won’t run out of money.
At the same time, people participating in the company’s defined benefit pension (DB) scheme can also rest easy. Higher long-term interest rates have also overhauled the health of the DB scheme, which pays inflation-linked lifetime pensions based on wages and years worked. For the first time in more than two decades, the chief financial officer is no longer losing sleep over pensions.
Monthly figures from the Pension Protection Fund for the UK’s 5,100 private sector DB schemes show the shift. The Pension Protection Fund is the lifeboat set up by the government to provide compensation in the event of a scheme failing.
these numbers Compare the value of assets (liabilities) required to pay all committed pensions at the PPF level with the assets held by the plan. From December 2021 to June 2023, the asset-to-liability surplus increases from £130 billion (about £1.8 trillion in assets and £1.7 trillion in liabilities) to £440 billion (about £1.4 trillion in assets and £1.7 trillion in liabilities) sterling liabilities). Only 500 schemes remain in deficit, with a total deficit of just £2.3bn.
Long-term bond yields have risen sharply, partly because of growth globally and partly because of the collapse of a “mini” budget at home in the UK, which has slashed PPF liabilities by a third. Assets fell by just a quarter, mainly in bonds held to match pension liabilities, bringing average funding levels to a record 145%.
For example, at BAE Systems, AA corporate bond yields (an accounting measure for DB liabilities) surged from 1.9% to 5.2% from December 2021 to June 2023. BAE’s UK pension liabilities fell by a third, from £28.8bn to £18.5bn, and assets fell by a quarter, from £27bn to £20bn, turning the scheme from deficit to surplus.
This is certainly good for businesses, reducing their deficit cash contribution, but is it good for the 9.5 million DB members?
Higher funding doesn’t mean higher pension – guaranteed ‘defined benefit’ pension promises don’t change depending on funding. But it does make pension promises less dependent on companies’ ability to write deficit-cutting checks, and therefore safer. Most plans can now pay all pension commitments even if the company goes bankrupt.
Better funding is good news for workers in the few programs that remain open and are now less likely to close. USS, the £71bn university scholars scheme, has strongly hinted that it will reverse the recent dilution of new pension commitments and reduce contributions from members and employers.
But lower debt and better financing don’t just depend on higher bond yields. A 5% cap on annual inflation-linked pension increases has also come into effect, bad news for pensioners.
Most large companies have introduced guaranteed inflation-linked pension increases, capped at 5%, since the late 1980s, usually in exchange for a contributory holiday. From 1997, all pensions are obliged to contribute to these pensions, and from 2005 the pension ceiling was reduced to 2.5%.
The annual increase in April is usually based on the retail price index (RPI) increase in the preceding September. In the 30 years from 1991 to 2021, the cap was only triggered once — RPI was 5.6% in 2001 — and then everyone forgot about it.
But with the retail price index (RPI) hitting 12.6% in September 2022, the 5% cap will hit pensioners again in 2023, cutting their inflation-adjusted real pension by 7.6%. The September 2023 RPI will also be above 5%, which will squeeze pensioners again in 2024. In practice, any pension earned after 2005 will be capped at less than 5%.
Some schemes, including small firms and privatized companies, use a lower consumer price index (CPI), so their pensioners are less squeezed than those whose RPI rises.
This is not a one-time “loss” for pensioners, which they can make up for in the future when inflation falls below 5%. It was a permanent “loss” for years to come.
The cap does not affect members who are not yet receiving a pension, as it applies to the average over the entire time they have been an ‘extended’ member and received their pension.
A group of wealthy BP pensioners is fighting for a portion of BP’s scheme surplus to pay discretionary increases to pensioners over the cap.
But discretionary raises are by definition not part of the scheme’s rules, so they cannot be paid without the employer’s consent, and BP will not budge, nor should it. After all, the point of caps is to share risk with members, and BP is delivering on its pension promises, leaving no stone unturned.
Some pension experts have offered half-baked ideas about what to do with the surplus, including partial repayments to employers. They want to encourage this by reducing the 35% tax charge on withdrawals, although that’s just a tax deduction to repay the company’s original contribution, plus tax-free investment returns in the pension plan.
The idea of repaying the surplus – perhaps at the same time with a discretionary increase – assumes that the company wishes to continue operating its closed pension scheme indefinitely. In fact, companies want to get out of the pension business as quickly as possible.
That means moving to full buyouts – the gold standard – to move pensions to well-capitalized and regulated insurers, and like many of the best-funded schemes, BP is preparing for an overhaul of its £30bn plan. Huge partial buyout. All this talk about guaranteed, inflation-linked DB pensions is going to upset millions of private sector people with defined contribution pensions and no guarantees. This is especially the case for companies with a minimum employer contribution of 3%, compared with an average of 10% for FTSE 100 companies.
Meanwhile, all public sector schemes, the NHS, teachers, civil servants, armed forces and local government remain open to new members and are more generous than 1/60th of private sector pensions. Also, surprisingly, there is no cap on how CPI inflation can go.
Can MPs and civil servants make inflation a risk in their own pension game by capping all future earned pensions at 5%?
John Ralfe is an independent superannuation consultant. X: @johnralfe1