Factoring in inflation
17th August, 2022
While many trustees are grappling with the impact of high inflation on their investment strategies and the potential for discretionary pension increases, there is an equally pressing issue to consider on the factors that are used for certain benefit calculations.
Early retirement factors
Of particular concern are early retirement factors (ERFs). The issue is fairly technical but boils down to the fact that most ERFs use a long-term estimate of deferred pension revaluation, which is driven by price inflation. However, the period over which they apply (generally less than 10 years and often as short as two years) is much shorter.
When inflation is fairly constant over the short and long-term then this doesn’t matter too much, because any small differences get lost in the rounding. However, when short term inflation is very high and long-term inflation is expected to fall significantly, as is the case at the moment, then the factors do not capture this.
What’s the typical impact?
If a member is currently looking to retire one year early then the ERF should allow for one year of deferred revaluation, which will be based on September CPI (or RPI). Expectations are that this will be around 10%, whereas the ERF would typically only allow for 3-3.5%, meaning members will receive an early retirement pension that is up to 7% lower than it otherwise would be.
This is a material shortfall when considered in the context of the legal requirement on trustees to be “reasonably satisfied” that the total value of the member’s early retirement benefit is at least equal to the total value of the member’s normal retirement benefit.
What can be done?
There are broadly three options available to trustees:
- Apply a short-term approximate adjustment to the factors, for example increasing all quotations for early retirement by a fixed percentage;
- Ask the Scheme Actuary to calculate an accurate adjustment for each member requesting early retirement; or
- Retain the existing factors but add a “health warning” to the member communication to highlight the potential loss of retiring now, rather than waiting another year.
In most cases, subject to scheme rules, a short-term approximate adjustment would appear to be the most appropriate course of action, although for smaller schemes the individual calculation would also seem to be viable. Regardless of the course of action, it’s important to highlight the issue to members seeking a quotation and to encourage them to seek advice and/or guidance.
Adjusting CETVs to reflect anticipated inflation is more of an issue for the Scheme Actuary, but trustees should check that such adjustments are being applied.
Other factors should also be considered (e.g. cash commutation, late retirement etc), but these are less likely to be sensitive to short term inflation expectations. As trustees, we are therefore unlikely to make any short-term changes unless we start to see long-term inflation expectations creeping up.