A combination of rising inflation and greater regulatory clarity could mean now is the right time for DB pension schemes to consider offering a Pension Increase Exchange to their members, according to LCP partner Clive Harrison.

Under current legislation, pensions built up in Defined Benefit pension schemes carry statutory protection against inflation (up to a limit).  For example, for service since April 1997, pensions in payment have to be increased by inflation (as measured by CPI) up to a cap of 5% for service up to April 2005 and up to 2.5% for service since then.  But some pension schemes may offer inflation protection over-and-above this statutory minimum.  A common example would be where inflation protection applies to pre 1997 service as well as post 1997 service, or where inflation is linked to the (generally higher) RPI rather than CPI.

Whilst this additional inflation protection is obviously of value to members, some might prefer their pension to be structured in a different way. In particular, they might be willing to exchange the non-statutory part of their inflation protection for a higher starting pension.  Members may be attracted to the idea of ‘front-loading’ their pension to a time in their retirement when they may be more active and more able to enjoy a higher income.  In addition, the offer of a higher starting pension could enable a non-pensioner member to retire sooner or secure a larger tax-free lump sum.

From the perspective of a pension scheme, offering to restructure benefits in this way may also be attractive.  For example, by removing non-statutory indexation, the scheme is less exposed to inflation (and longevity) risks and therefore has to spend less on hedging against these risks.  Furthermore, PIE exercises can also improve the overall funding position of the scheme, for example, if the value of the inflation protection withdrawn is converted into higher starting pensions on a best estimate basis.  There is of course a cost to such exercises and schemes will need to weigh the pros and cons given the specific circumstances of their individual scheme.

Although Pension Increase Exchanges (PIEs) of this sort already happen, LCP believe that three recent developments mean that they may now be attractive to schemes:

• Some schemes have been reluctant to undertake PIE exercises whilst the rules around GMP equalisation have remained unclear; however, recent guidance from the Pensions Administration Standards Association (PASA) has provided guidance on how schemes can tackle GMP equalisation by ‘conversion’ of scheme benefits; this approach potentially increases the amount of benefits where inflation protection can be exchanged for a higher starting pension and allows schemes to conduct GMP conversion and a PIE as a single process; 
• Expected levels of inflation are now rising; this means that the value of non-statutory indexation increases and allows schemes to offer a larger increase in starting pensions in exchange for giving up this protection; it also makes it more attractive for schemes to reduce their exposure to inflation
• Uncertainty over changes to the Retail Prices Index (RPI) have meant it has been harder for schemes to predict the value of future pension increases and set PIE conversion terms; however, a final decision has now been announced on changes to RPI which allows schemes to plan with greater certainty;

Whilst a PIE will not be appropriate for all schemes, and members need to be given proper help and advice to make the choice which is right for them, LCP believes that a PIE can offer a ‘win-win’ for schemes and members alike.

Clive Harrison, partner at LCP said:

“Given the trend on inflation, and recent helpful guidance on GMP conversion, I expect to see more trustees and scheme sponsors introduce a PIE option as they continue to de-risk whilst at the same time provide an attractive option to members.  With some of the barriers now removed, the time is right for schemes to consider whether this would be right for them and their members, potentially as part of a wider process of GMP equalisation”.

Clive Harrison’s blog on the case for more schemes to consider a PIE can be read here