I am in receipt of a private defined benefit pension. Approximately two thirds of my benefits were accrued before April 1997.
The fund rules for pre-1997 pension accruals do not provide for increases in excess of any Guaranteed Minimum Pension. Increases may be provided at the discretion of the company.
However, the company recently advised that no increase would be made this year. In fact no discretionary increase has been made since 2009.
Pension benefits: My old employer hasn’t made a discretionary increase in the payments since 2009
Obviously I am concerned that over time the value of my pension will decrease significantly in real terms due to inflation.
Is there anything I can do other than hope that my former employer feels some moral obligation to increase the pension to take account of inflation?
Also, for the purposes of the Lifetime Allowance calculation is it correct that all defined benefit schemes are valued on the same basis irrespective of whether inflationary increases are discretionary, guaranteed or capped?
I exceeded my Lifetime Allowance and therefore was hit with a punitive tax. However my defined benefit scheme, which has no guaranteed inflation increase, is clearly worth less than one that is protected to some extent against inflation.
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Steve Webb replies: With prices rising rapidly it is obviously important to understand how far your pension is going to be protected against inflation.
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For old style defined benefit pensions such as yours, there are three different forms of inflation protection to be aware of:
– Statutory inflation protection, which is guaranteed by law;
– Inflation protection under the rules of the scheme, over and above any legal minimum;
– So-called ‘discretionary’ increases which the scheme does not have to pay you but may choose to pay you.
Statutory protection against inflation is through a process known as ‘limited price indexation’.
For your service in the scheme from 1997 to 2005, the scheme has a legal obligation to provide protection against inflation up to a cap of 5 per cent and for service from 2005 onwards the cap is 2.5 per cent.
For these purposes, inflation is now measured using the Consumer Prices Index (CPI) measure of inflation.
The second element of statutory inflation protection is where your company pension was ‘contracted out’ of the state earnings-related pension scheme (SERPS).
For service up to 1997, instead of your SERPS pension, the scheme has to provide you with a Guaranteed Minimum Pension. For GMP built up between 1988 and 1997, this has to be index-linked by inflation, capped at 3 per cent.
Turning next to increases in line with scheme rules, some pension schemes have rules which require them to pay inflation increases which are more generous than those required by law.
One example would be where the scheme rules require annual increases to be linked to the Retail Prices Index (RPI) measure of inflation rather than the currently much lower CPI measure.
Another example would be where the scheme rules provide for inflation protection for all service and not just service since 1997.
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Because of the limited nature of inflation protection offered by law, and sometimes the limited protection offered under the scheme rules, there is now likely to be a focus on the third category of protection – ‘discretionary’ increases.
These are increases which the scheme is not obliged to pay under the law or the rules of the scheme but which they might choose to pay in any case.
In many cases this would be at the discretion of the trustees though in your case it sounds as though the rules specify that these increases are at the discretion of the employer.
At this stage it is hard to know if many (or even any) defined benefit pension schemes will pay larger increases to reflect higher inflation.
It is probably fair to assume that defined benefit schemes which are currently poorly funded and may struggle even to fund existing pension promises are highly unlikely to pay discretionary increases on top.
But it is possible that well-funded schemes, perhaps with the support of an engaged employer, may choose to do so.
Ultimately this will be a decision for the scheme, and you could always contact them to let them know how much difference a larger increase would make.
But if they refuse to pay discretionary increases there is unlikely to be anything you can do, provided that they have correctly followed the rules.
Turning finally to your other question, this is about the way in which defined benefit pension rights are tested against the Lifetime Allowance (LTA) when it comes to pension tax relief.
The LTA is a measure which tries to put an overall limit on the amount of pension tax relief which people can enjoy, and it is currently £1,073,100.
The amount of your LTA which is eaten up by your defined benefit pension is (in simple terms) 20 times your pension at retirement plus any lump sum which you draw.
As you have noted, this rule is rather unfair. You could have two pension schemes which pay identical pensions at retirement but one of which offers much more generous indexation through retirement.
The pension with the better indexation is clearly more valuable but both ‘eat up’ exactly the same amount of the LTA.
I suspect that HMRC decided that it was simply too complex to try to value the future stream of pension payments and that a ‘times twenty’ rule was a rough-and-ready way of testing defined benefit rights against the Lifetime Allowance.
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Steve left the Department of Work and Pensions after the May 2015 election. He is now a partner at actuary and consulting firm Lane Clark & Peacock.
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