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Interest rates and pensions: good news and bad

The much higher interest rates we have seen in the past few months are clearly bad news for borrowers, especially for younger people trying to buy their first home.

And higher long-term interest rates, pushing down the value of bonds, have hit the value of defined contribution (DC) pension pots, even though equities are up.

However, it’s not all bad news, particularly not for older Britons. For those with a DC pension who have retired, or nearing retirement, higher bond interest rates are very good, because they have reduced the cost of buying an annuity — a guaranteed pension for life, which can be inflation linked. 

The annuity which can now be bought with a DC pension pot has increased by a half in the past 18 months.

For the first time in a long time, annuities look “good value” versus keeping your DC savings and drawing down each month, but with no guaranteed amount and no guarantee you won’t run out of money.

Meanwhile, people in company defined benefit pension (DB) schemes can also rest easier. Higher long-term interest rates have also transformed out of all recognition the health of DB schemes, which pay a guaranteed inflation-linked pension for life, based on salary and the number of years worked. For the first time in over 20 years, finance directors are not losing sleep over pensions.

The monthly figures for the UK’s 5,100 private sector DB schemes from the Pension Protection Fund, the lifeboat set up by the government to pay compensation when a scheme goes bust, show this transformation.

These figures compare the value of assets needed to pay all promised pensions at the PPF level — liabilities — with the assets held by schemes. From December 2021 to June 2023 the surplus of assets over liabilities increased from £130bn, around £1.8tn assets and £1.7tn liabilities, to £440bn, around £1.4tn assets and £1tn liabilities. Only 500 schemes are still in deficit, with a total deficit of just £2.3bn.

Much higher long-term bond yields, driven partly by worldwide increases and partly by the UK’s homegrown “mini” Budget debacle, have slashed PPF liabilities by a third. Assets fell by just a quarter, mainly bonds held to match pension liabilities, leaving average funding levels at a record 145 per cent.

At BAE Systems, for example, from December 2021 to June 2023, AA corporate bond yields, the accounting measure of DB liabilities, shot up from 1.9 to 5.2 per cent. 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, moving the scheme from a deficit to a surplus.

This is all certainly good for companies, reducing their deficit cash contributions, but is it good for the 9.5mn DB members?

Higher funding doesn’t mean higher pensions — the guaranteed “defined benefit” pension promise doesn’t change depending on funding. But it does make the pension promise less dependent on the company’s ability to write deficit reduction cheques, and therefore more secure. Most schemes can now pay all pension promises, even if the company goes bust.

Better funding is good news for staff in the few schemes still open, which are now less likely to close. USS, the £71bn scheme for university academics, has dropped heavy hints that it will reverse the recent dilution of new pension promises, and reduce member and employer contributions.

But lower liabilities and better funding aren’t just down to higher bond yields. The 5 per cent cap on annual inflation-linked pension increases has also kicked in, bad news for pensioners.

Guaranteed inflation-linked pension increases, capped at 5 per cent, were introduced by most large companies from the late 1980s, usually in exchange for contribution holidays. They became legally required for all pensions earned from 1997, with the cap reduced to 2.5 per cent for pensions earned from 2005.

April’s annual increases are usually based on the previous September’s retail price index (RPI) rate. In the 30 years from 1991 to 2021 the cap was triggered just once — RPI was 5.6 per cent in 2001 — and everyone forgot about it.

But the September 2022 RPI hit 12.6 per cent, so the 5 per cent cap is back to bite pensioners in 2023, cutting their real inflation-adjusted pensions by 7.6 per cent. The September 2023 RPI will also be higher than 5 per cent, squeezing pensioners again in 2024. And, in practice, the cap will be lower than 5 per cent for any pension earned after 2005.

Some schemes, including small companies and privatised companies, use the lower consumer price index (CPI) rate, so their pensioners are squeezed less than those with RPI increases.

This isn’t a one-off “loss” for pensioners that they can clawback as future inflation falls below 5 per cent. It is a permanent “loss” for all future years.

The cap doesn’t hit members not yet drawing their pension, because it is applied to them as an average over the whole time from becoming a “deferred” member to drawing a pension.

The well-heeled BP pensioners’ group is campaigning for part of the BP scheme surplus to be used to pay discretionary increases to pensioners above the cap.

But discretionary increases, by definition, are not part of the scheme rules, so cannot be paid without the employer’s consent, and BP isn’t budging, and shouldn’t budge. After all, the cap is designed to share risk with members, and BP is meeting its pension promises, down to the last penny.

Some pension pundits have come up with half-baked ideas of what should happen to surpluses, including a partial repayment to employers. They want to encourage this by reducing the 35 per cent tax charge on withdrawals, even though it simply repays the tax break on the company’s original contributions, plus tax-free investment returns in the pension scheme.

The idea of repaying surpluses — perhaps along with giving discretionary increases — assumes that companies want to continue running their closed pension schemes indefinitely. In truth, companies want to get out of the pensions business as soon as possible.

This means moving to a full buyout — the gold standard — transferring pensions to a properly capitalised and regulated insurance company, and like many of the best funded-schemes, BP is limbering up for a jumbo partial buyout of its £30bn scheme. All this talk of guaranteed, inflation-linked DB pensions will stick in the throats of millions in the private sector with defined contribution pensions, and no guarantees. This is especially true for those on the minimum 3 per cent employer contributions, versus an average of 10 per cent for FTSE 100 companies.

Meanwhile, all public sector schemes, the NHS, teachers, civil service, armed forces and local government, are still open to new members, and more generous than a 1/60th private sector pension. Also — surprise, surprise — there is no cap on CPI inflation increases.

How about MPs and civil servants putting inflation as skin in the game for their own pensions, by introducing a 5 per cent cap for all future pensions earned?

John Ralfe is an independent pensions consultant. X: @johnralfe1

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