Alan Collins: Inflation a mixed 'blessing', unless you are a pensioner

Published on Wednesday 22 June 2011 22:20

MERVYN King's writing hand must be feeling the strain of the inflationary pressures in the UK's economy. For six quarters in a row, the Bank of England governor has had to draft a letter to Chancellor George Osborne to explain why the UK government's inflation target has been missed.

High inflation is not always bad - it can encourage economy-boosting spending and more private investment in companies as many investors see stocks and shares as a better option than cash.

Unfortunately, it also provides a lot of instability in the economy and the world of pensions. Over the past year, inflation has been the biggest issue on our radar, not least because of the contentious legislation to determine pension valuations based on consumer price index (CPI) rather than the previous gauge of retail price index (RPI) being introduced in the UK.

The recent announcement that CPI rose by 4.5 per cent over the past year compared with an increase in RPI of 5.2 per cent will have a direct economic effect on many pensioners. Those with pensions linked to RPI would gain by almost 1 per cent each year compared to those with pensions linked to CPI. Assuming these inflationary rises continued at their present rates, the income of a pensioner currently earning 10,000 each year would rise to just over 16,600 per annum in ten years' time under RPI compared with around 15,500 per annum under CPI.

Inflation as it effects pensioners is generally accepted to be relatively higher as the "basket of goods" includes many items that have increased more rapidly recently, such as food and fuel costs. These tend to represent a greater proportion of income spend for a pensioner whereas other areas of expenditure which have been more stable or reduced.

The current high levels of inflation are highlighting the controversy over the move from RPI to CPI. We have already seen many public-sector union leaders calling for a judicial review on this decision and the private sector is not exempt from this either. In April, three trustees of the British Airways pension fund resigned because of the move from RPI to CPI.

Future movements in CPI are very difficult to predict. Even over recent years, there have been a number of occasions that CPI has exceeded RPI so it can therefore not be ruled out that CPI could on occasion give rise to higher increases than are currently paid under RPI. The basket of goods for CPI could also change - if, for example, housing costs are included, this could substantially close the current gap between it and RPI.

Looking at the impact of inflation from a different perspective, it can also have a roller-coaster effect on pension scheme payments and funding levels. Inflation caps on pension increases are often overlooked. Pensions may become significantly devalued if this cap applies for an extended period.Pension increases are generally capped at a maximum of 5 per cent per annum, and so with inflation at its current level, capping at the 5 per cent level would currently apply under RPI and remain a distinct possibility for the future.

While it would be bad news for pensioners and possibly the wider economy, a run of higher inflation is actually likely to improve scheme funding. Providing the actual inflation level exceeds any cap that a scheme has in place, it will be providing its members below inflation increases which, assuming investment returns do keep pace with inflation, will improve the overall funding of the scheme. The worst-possible scenario for scheme funding is likely to be in a period of deflation whereby they would need to effectively pay out increases in excess of inflation and reduce scheme funding.

Perhaps the fine balancing act and the cause and effect implications of rising inflation explain the apparent willingness of the Bank of England and the government to live with this situation, at least in the short term. However, the longer King is required to pen an inflation letter to the Chancellor, the greater impact this will have on UK pensioners.

• Alan Collins is head of corporate advisory services at pensions consultancy Spence & Partners.