Never mind the triple lock – what’s happening with company and private pensions?
For many of us pensions are something we’re already receiving or expect to receive in the next few years. But what’s happening to their value in these challenging times? Nim Maradas, who is a trustee of a large pension scheme, has kindly taken the time to explain how different pensions work, and what we can do to better understand our positions.
Do all pensions keep up with inflation?
It’s great news for pensioners that the government has announced the State pension ‘triple lock’ stays in force for the coming year – assuming the decision survives another change of prime minister. It should mean a 10.1% increase from April next year. But what about company pensions, personal private pensions and – for those who’ve retired more recently – drawdown accounts?
The answer hasn’t mattered too much in recent years, when inflation has been low and most investments have gone up strongly. But now that has gone into reverse: this year’s £100 is already only worth just over £90 at last year’s prices, and practically every sort of investment has lost value.
Unfortunately, there’s no simple answer to how your pension or pensions will keep up. As this article explains, everything depends on what sort of scheme you’re in and a lot of small print you’ve probably never worried about until now. Some practical steps are set out at the end to help you chart a way through these unpredictable financial times.
Why inflation matters
Anyone in their late 60s or older will remember 1975, when UK inflation averaged 23%. We’re nowhere near that level now but think what it would have meant if your income hadn’t kept pace. On average, things that cost £100 on January 1st would have cost £123 by the end of the year.
Inflation was 16.5% the following year, taking the cost to £143. And so on. Anyone on a fixed income – or living by running down their savings – found their standard of living massively reduced. It took until 1978 to bring inflation back to single figures, by when many older people had been financially wiped out.
There have been huge changes to the pensions landscape since then and, of course, the country is on average much richer. However, at least 1.4 million people in the UK receive Pension Credit – broadly bringing their income to the same as the full State pension of £185.15 a week – and many more have only small private pensions on top of that.
For these people in particular, and indeed for anyone dependent on pension income, keeping pace with inflation has become a pressing issue.
Three different kinds of pension
The starting point is to understand what kind of pension or pensions is involved, because three very different financial arrangements are often included under the same umbrella.
- A defined benefit (eg final salary) pension pays an income, usually calculated on the number of years worked for a given employer and your salary when you left. There are variations, for example using your average salary rather than final one. But in all cases the “benefit” (ie the pension payable) is “defined” (ie governed) by the scheme rules, and ultimate responsibility for delivering it lies with the employer sponsoring the scheme.
- A defined contribution (DC) pension is much more like an ISA or any other form of savings, though it’s governed by special rules and has favourable tax status. It can be your own individual pension pot, for instance a SIPP, or an employer scheme. Most people currently in employment have this sort of pension which they and the employer both contribute to. When you come to retire, you have various options including drawdown (where you can take money out as and when you need it) or moving to the third basic type, an annuity.
- An annuity is when you hand over a lump sum to an insurance company in exchange for a guaranteed income – normally for life. There are lots of people still around who were effectively forced to swap their DC pensions pots for an annuity when they reached 75, under rules that were only abolished in April 2011.
Different factors affect the extent to which each of these three may or may not provide protection from inflation.
Defined benefit (DB)
All DB schemes operate under rules that define where the money comes from, the way in which each member’s pension is worked out, the age at which pension can be taken and the arrangements (if any) for increasing pensions over time.
A typical employer scheme in the 1980s or 1990s, for instance, might provide 1/80th of a member’s final salary per year worked, assuming retirement at 62 and increasing by the higher of inflation or 5% every year on 1st January. All these basics can vary according to the individual scheme’s rules. Some schemes have no annual increase, however fast prices rise. Others have unlimited inflation protection. There are any number of variations in between.
Company schemes generally have a board of trustees who work on behalf of members to ensure there’s enough money to pay pensions when they’re due.
The money paid in while members are working builds up in a massive pot combining employer and employee contributions. It’s invested and if the pot’s not big enough to cover all the pensions due, the company has to put in extra cash. If the company goes bust, there’s a Pension Protection Fund which pays most of the benefits due. If there’s more than enough money in the pot, depending on the scheme rules the trustees may be able to offer extra pension increases – or it may go to the employer.
Public sector pensions work differently, though the arrangements have increasingly got closer to private sector ones.
If that sounds complicated, there’s more. Most company schemes have lots of different sections, with different rules, inherited from companies they have taken over. That means individual members of the same scheme can get very different pensions – and different annual increases – for the same salary and length of service.
Finally, there is something called Guaranteed Minimum Pension (GMP), which is calculated according to a specific formula and follows different rules. GMP is far too complicated to explain here but it’s important because it means part of your pension (built up between April 1978 and April 1988) may not have to be increased for inflation, and part (between April 1978 and April 1988) by inflation only up to 3%.
The upshot – it’s almost impossible for most pensioners to calculate what they’re due. Your next annual increase could be 10% or more; or it could be a big fat zero. If in doubt, contact your scheme administrator, who will be able to explain the rules that apply to your individual pension and when any pension increase will be paid.
Defined contribution
DC pensions work under a different set of rules, which are much simpler. The money has your name on it, it builds up while you’re working, and gets spent when you need it.
Think Mount Everest. It’s incredibly hard to get to the top (ie to build up enough money to keep you for up to 40 years of retirement). There’s a great moment when you reach the summit and start going back down (because you can take 25% tax-free cash). But if you’re not careful, you find yourself bumping far too quickly back to the bottom, having spent the rest, at a time in life when you when you might need the money most.
People usually choose drawdown when they start heading back down Everest, partly because they may be able to pay into another pension while spending that lovely 25%. The problem with this is that the remaining pot is at the mercy of those mysterious financial markets that have been causing such mayhem over recent weeks.
So far in 2022, you’d have been doing well to maintain the same cash value in your fund – meaning that it’ll buy nearly 10% less than this time last year. At worst, it may have dropped badly. So that means either taking out less money out in real terms in future, or running out of money sooner. On the upside, that decision is in your hands as you can take as much as you like out of the pot. Beware Income Tax, though – you could take a big hit.
If you have a financial adviser, talk to them. If you haven’t, and you’re worried, contact an organisation like Money Helper, where you can get free and impartial guidance. Be very careful who to trust if they offer help – there are a lot of scammers out there, trying to get their hands on your hard-earned pension pot.
Annuity
An annuity is very similar to a DB pension but is governed by an individual contract between you and the insurance company. You should have been offered a choice when you took out the contract between a ‘level’ annuity (ie one that pays the same amount every year) or one with annual increases and/or an inflation link. Once you’ve taken out an annuity, you can’t change your mind.
Annuities have gone out of fashion recently because it’s been so expensive to buy any reasonable amount of income. That’s mainly a function of interest rates, and one of the few good things about the recent turbulence is that you can now get a bigger income for life, for the same amount of cash.
There are as many variations in annuities as company pensions, so shop around carefully if you’re thinking of getting one – especially if you’re not in good health – and take advice or guidance before committing. If you already have one, check what it says about inflation, and plan accordingly.
What to do next
It is important to take a cool look at your savings and investments, and ensure you understand what recent events and high inflation mean for your income. That may mean doing some painful legwork to check how each element will stand up to rising prices. Only then can you budget.
There are lots of places to go for help.
- Start by contacting the administrators and other companies who look after your pensions and/or annuities to ask about your individual accounts
- Track down any pensions from long-ago jobs you might have forgotten about – gov.uk has a helpful pension contacts database
- Websites such as Money Helper and Age UK have lots of useful information and helplines where you can ask impartial experts for help
- Take advice from a financial adviser – there’s an adviser directory on the Money Helper website. This isn’t cheap so ask lots of questions before you commit, and beware of scams.
- Don’t bury your head in the sand if you get into debt – there’s lots of free debt advice out there so you can get your finances back on track.
