What’s the impact of high inflation on pensions?

Many Prospect members have asked about the potential impact of high inflation and low real pay growth on their pension. Neil Walsh, our pensions officer, has a look at the details.

Inflation, as measured by the Consumer Prices Index (CPI), jumped to 10.1% in July 2022. In its August 2022 Monetary Policy Report, the Bank of England said it expected higher energy prices to push inflation to around 13% over the next few months.

Under the relevant legislation, public service pensions are increased every year by the same rate as the additional state pension. The statutory requirement is for the additional state pension to increase by at least as much as inflation. The legislation does not specify how inflation should be measured, but the government has used CPI for this purpose for a number of years (previously the Retail Prices Index – RPI – was used).

The increase in public service pensions is applied in April every year and is based on the increase in CPI in the 12 months to the previous September. Pensions that have been in payment all year get the full increase, and pensions that were in payment for part of the year get a pro rata increase.

The combination of these rules and the current inflation environment is expected to result in public service pensions increasing by something between 10% and 13% next April (with pro-rata increases for some pensions that are put in payment during the year).

By contrast, public sector pay increases will be much lower. Different parts of the public sector have different remits and different groups within the same organisation can have different increases; but many civil servants will see pay increases limited to 2% due to the Civil Service Pay Remit guidance for 2022 to 2023.

Consequently, some Prospect members in the civil service are asking whether they would be better off opting out of their pension scheme and securing significant inflation protection, rather than staying in a scheme that is linked to (falling) real pay growth.

Prospect is not authorised to give financial advice of this nature. Members of most sections of the civil service pension scheme are likely to be better off staying in the scheme (many do not have a link between their benefits and pay growth). The following information might be useful for people considering this issue:

Partnership

A relatively small number of civil servants choose to contribute to the Partnership pension scheme. Contributions to this scheme are invested in a range of assets. The retirement income that the Partnership pension can provide is linked to the level of contributions that were made and the rate of return that was achieved on the investments. There is no direct relationship between benefits from this scheme and inflation or pay increases.

Those who are not contributing to the Partnership pension scheme, will be in the Alpha scheme instead. However, members of Alpha will have come to that scheme from a number of other pension schemes and this pension history can make a significant difference to the impact that inflation will have on them.

Alpha (always in the Alpha scheme)

Alpha is the defined benefit scheme that has been available to new joiners since April 2015. If you have joined since then, all your defined benefit accrual will be in Alpha. Your Alpha benefits increase in line with inflation as measured by CPI, there is no link to pay.

Alpha (previously in the Nuvos scheme)

If you joined the civil service between July 2007 and April 2015, the defined benefit scheme originally available to you was called Nuvos. You would have moved from Nuvos to Alpha either in April 2015 or April 2022 or, more rarely, at some date in between. If you joined before 31 March 2012, you will have a choice to treat service between April 2015 and April 2022 as being in Nuvos or Alpha. Like Alpha, Nuvos benefits increase in line with inflation as measures by CPI, there is no link to pay.

Alpha (previously in Premium scheme or Classic Plus)

If you joined the civil service between October 2002 and July 2007, the defined benefit scheme originally available to you was called Premium. If you joined before October 2002, you could choose to opt into the Premium scheme (if you did this for all service you were a full member of Premium, if you did this for just future service it was called Classic Plus). You would have moved from Premium to Alpha either in April 2015 or April 2022 or, more rarely, at some date in between. You will have a choice to treat service between April 2015 and April 2022 as being in Premium or Alpha.

Premium is a final salary pension scheme, the pension built up in this scheme is based on the calculation of final pensionable pay when you leave the civil service’s defined benefits pension arrangements (ie when you leave Alpha, not the pay when you moved from Premium to Alpha). There are three ways of calculating final pensionable pay in the Premium scheme (these also apply to Classic Plus members):

1. Pensionable pay in the last 12 months
2. Highest pensionable pay in any of the last 4 complete scheme years
3. Highest average pensionable pay in any period of 3 complete scheme years during the last 13 years

The calculation that gives the best answer is used. If earlier years’ pay is used (eg for calculation (2) or (3) above) then these are adjusted by inflation. Consequently, members of Premium and Classic Plus can still potentially benefit from the current high level of inflation when the final pensionable pay is calculated for many years to come. If the current level of inflation ever drops out of the calculation of final pensionable pay entirely, then there may have been enough time for pay to have grown in real terms (through promotions or otherwise) by the time of retirement anyway.

Alpha (previously in Classic scheme)

If you joined the civil service before October 2002, the defined benefit scheme originally available to you was called Classic. Some Classic members may have opted to join Premium of Classic Plus when this option was available. If you stayed in Classic at that time, you would have moved from Classic to Alpha either in April 2015 or April 2022 or, more rarely, at some date in between. You will have a choice to treat service between April 2015 and April 2022 as being in Classic or Alpha.

Classic is a final salary pension scheme, the pension built up in this scheme is based on the calculation of final pensionable pay when you leave the civil service’s defined benefits pension arrangements (ie when you leave Alpha, not the pay when you moved from Classic to Alpha). The definition of final pensionable pay in the Classic scheme is the best 12 months’ pay in the last 36 months. In practice, this is usually pensionable pay in the last 12 months.

Due to the way final pensionable pay is calculated in Classic, it can be possible, at a time of high inflation and low pay growth, for someone to get a higher pension by opting out of the pension scheme and securing inflation protection for their accrued benefits, even at the cost of missing out on additional years’ service. This is particularly the case for members who have a lot of service in the scheme (though many members will not know how much service they have in Classic as it is possible that the period between April 2015 and April 2022 may be treated as Alpha rather than Classic).

An example may best illustrate this (this example assumes the increase in CPI in the 12 months to September 2022 will be 10% and that salary growth will be 2%):

Example – Sue

Sue’s details:

• Started in the civil service in April 1982 aged 20
• 60th birthday in April 2022
• Earning £40,000 working full-time

So, by April 2022, Sue had:

• Accrued pension of £20,000 payable immediately (ie 40/80ths of final salary)
• Tax-free lump sum of 3 times the pension or £60,000

If Sue opted out of the scheme at the start of the year, she would:

1. Be due a pension of £22,000 from April 2023 (ie assume CPI – 10%)
2. Tax-free lump sum of 3 times the pension of £66,000

If Sue stayed in the scheme, she would:

1. Accrue £946.56 pension in Alpha payable from age 67 or £683.42 payable from April 2023
2. Have accrued Classic pension is worth £20,400 (ie increased in line with salary)
3. So total pension payable from April 2023 would be £21,083.42 (accrued plus Alpha)
4. The accrued tax-free lump sum is now worth £61,200

So, by staying in the scheme for the year, Sue has:

1. Paid contributions to the scheme
2. Accrued £916.58pa less pension payable from April 2023
3. Lost £4,800 in tax-free lump sum

This example clearly shows how a final salary link can be detrimental to pension entitlement at a time when salary is falling in real terms.

The main features of this example were deliberately chosen to highlight the nature of this problem, rather than to be representative of Classic members overall or to suggest that any specific Classic member would be better off opting out of the scheme due to high inflation and real terms pay cuts.

In particular, a longer time horizon and / or a recovery in real pay levels (both of which are more likely to apply to younger members) would make staying in the scheme look relatively more attractive that opting out.

It is important for Classic members to consider their own circumstances and plans for the future before making any significant decisions about pension provision. An issue as important as this is worth getting independent financial advice on.

It is also important to know that there are alternatives to opting out of all pension provision that can still ensure your accrued Classic pension gets inflation protection.

If you are above minimum pension age in Classic (50) then, if you reduce your earnings by at least 20%, you can partially retire and put your Classic pension into payment. Your Classic pension will attract inflation protection from this point. However, if you put the Classic pension into payment before age 60, it will be reduced to reflect the fact that it will be in payment for longer. Also, if the Classic pension added to your reduced earnings is more than your earnings before partial retirement then it will be reduced to bring your total earnings down to this level (this is known as abatement). Hence, this option is particularly suited to members who are 60 or older.

Another alternative to opting out of all pension provision, is to switch to the Partnership scheme. This has the same effect of linking accrued pension in Classic to inflation but also allows members to benefit from further employer contributions to the Partnership scheme.

If you would like more information, or think you would benefit from a webinar on this issue, please contact: [email protected] in Prospect’s research team to register your interest.