Increasing defined benefit pensions: how should trustees and employers proceed?

Out-Law Analysis | 16 Aug 2017 | 4:41 pm | 5 min. read

ANALYSIS: Recent developments around how defined benefit (DB) pension scheme benefits should be increased for inflation mean now is a good time for trustees and employers to take stock and consider their options.

Many schemes still use the Retail Prices Index (RPI) to increase deferred pensions and pensions in payment. However, RPI is no longer recognised as a national statistic, and the National Statistician, John Pullinger, "strongly discourage[s]" its use since there are "far superior alternatives".

Employers and trustees are struggling to know what to do. The position under scheme rules can be confusing. The government's green paper on DB pension schemes suggested that the government might consider making changes, and new measures of inflation might replace RPI and the Consumer Prices Index (CPI) in any event.

Trustees and employers should make sure they properly understand what their scheme rules currently provide for, and what changes may be allowed. Legal advice may well be required in interpreting scheme rules in the light of recent case law. Trustees need to be aware that changes are in the offing, although current politics may have delayed things. Any legislation that eventually flows from the green paper, and the potential adoption of a different index as best for inflation protection, could have a considerable impact on future funding levels and member benefits.

The original policy and 2010/11 legislative switch

There is now a statutory requirement to revalue deferred pensions and to increase pensions in payment. Separate requirements apply to contracted-out benefits.

These increases were originally based on RPI, subject to a cap; but the government later recognised there were problems with RPI and decided to take action. In 2010, then pensions minister Steve Webb announced that the government believed CPI provided a "more appropriate measure of pension recipients' inflation experiences", as well as being consistent with the measure of inflation used by the Bank of England.

However, when the government introduced the relevant legislation to make CPI the measure of inflation in determining increases for all occupational pensions, it failed to implement a statutory override to ensure that the measure would take effect across the board. Instead, the switch too effect in only about 20-30% of schemes. Schemes that happened to contain a provision in their rules specifically referring to, and therefore 'hard-wiring', RPI were unable to switch to CPI.

The result was an inflation protection lottery: whether a scheme switched to CPI or not depended on how inflation protection happened to be provided for in the scheme rules.

What the courts and Ombudsman have decided so far

Some pension scheme members have objected to switches from RPI to CPI on the basis that member booklets or other communications led them to believe RPI would always apply. The Pensions Ombudsman has dismissed these complaints. Member communications are rarely binding in the same way as scheme rules. Only in unusual circumstances could members validly claim that they would have made a different financial decision had they known that a switch to CPI would be made.

The courts have also generally supported switches from RPI to CPI. They have ruled that trustees may agree to use CPI instead of RPI, even where the switch applies to pensions that have already built up under the scheme. However, this is only possible if the scheme rules have always provided an option to adopt another index - and the precise wording of that option is critical.

For example, if the rules state that the relevant index is "the general index of retail prices published by the Department of Employment or any replacement adopted by the trustees", the trustees cannot simply adopt any other index: they can only adopt the replacement index chosen by the government. Since RPI is still published, there has been no replacement. At least, that was the view of the Court of Appeal in November 2016, in the Barnardo's case, although things may change as this case is going on appeal up to the Supreme Court. Since many schemes have wording along these lines, the final outcome will have a significant impact.

In the Thales case, in March 2017, the rules allowed a switch from RPI if that index's "compilation materially changed". The High Court ruled that the composition of RPI had materially changed on the recent incorporation of the UK House Price Index into RPI. However, the scheme rules in this case only allowed a switch to "the nearest alternative index". The court decided that the nearest alternative index to the original RPI was... the RPI as currently constituted!

Although the sort of wording considered by the court in the Thales case is rare, that case, alongside the Barnardo's case, demonstrates that it can be far from easy to determine whether trustees and employers can lawfully switch to CPI even if they agree that it is the right thing to do. Provisions differ widely from scheme to scheme. Courts have struggled to make sense of wording that often predates the invention of CPI, and we are still waiting to learn from the Supreme Court what one of the most common form of words means.

It is one thing for trustees to have the power to make the switch. It is another for the trustees to decide that it's appropriate to push ahead. Recently the High Court refused, despite objections from scheme employer British Airways, to overturn the decision by the trustees of the Airways Pension Scheme to move in the opposite direction from most schemes: from CPI to RPI. Although British Airways are now taking this matter to the Court of Appeal, the case does demonstrate that trustee decisions, however controversial, will stand as long as the trustees have acted within their powers, followed the correct procedures and taken into account relevant, and ignored irrelevant, considerations.

The green paper

In its green paper on DB pension schemes, the government was minded not to abandon or reduce inflation protection for all schemes. Instead, it proposed suspending increases where employers are struggling to pay off a scheme deficit. The government did recognise the inflation protection 'lottery' explained above, and has been considering introducing a statutory override to introduce some fairness. That override could save employers - or cost members - £90 billion.

It is far from clear what the government will now do about all this. Much will depend on the responses the government has received to its consultation and on the changed political priorities since the general election. There was no sign of a Pensions Bill in the post-election Queen's Speech.

CPIH, HCI or something else?

CPI has its critics, particularly because it excludes certain housing costs. The index known as CPIH is essentially the same as CPI, but it does include owner-occupiers' housing costs and council tax. However, the Office for National Statistics needs to carry out further work before CPIH achieves the status of a national statistic.

The Royal Statistical Society (RSS) believes that neither CPI nor CPIH meets the 'public confidence' test. Both were designed for international, macroeconomic purposes, rather than to measure national household inflation – and both remain subject to EU rules, which could become politically sensitive. The RSS instead favours the Household Costs Index (HCI) as a longer term solution for pension schemes.

The Office for National Statistics is currently working on the design of HCI, but it could be a long time before any teething problems are sorted out and it becomes widely accepted. The RSS has suggested that the government should implement a switch to an 'RPI minus x' formula pending the adoption of HCI, rather than move all pension schemes onto CPI.

Simon Tyler is a pensions law expert at Pinsent Masons, the law firm behind Out-Law.com.