Inflation traders calm on talk of threat to UKpension indexationPensions minister Steve Webb toldthe Financial Times this month thatscrapping the link between definedbenefit (DB) pensions and inflationcould reduce employer costs andhelp prevent closure of DB schemesin favour of less attractive definedcontribution (DC) schemes in the future.“I am saying we shouldn’t just let thependulum swing all the way to puredefined contribution,” Webb said.“What I want is to try and create anenvironment where the pendulumcan swing back a bit.” He continued:“Clearly indexation is the biggest cost[for companies].” Later, an unnamedDWP spokesperson told newswireIPE that: “We’ve committed toreinvigorating private pensions…butno decisions have been made.”In raising the subject of the costof indexation, Webb re-opened adebate that has been bubbling awaysince July 2002, when the PickeringReport recommended scrapping theobligation to index-link pensions.Unions were at the forefront ofopposition to this proposal 10 yearsago, and again, over the weekend,the Unite union general secretary LenMcCluskey warned that “a pensionwith no guaranteed increase is notreally a proper defined benefit at all,as an absence of increase could easilyhalve its value.”So after 10 years of behind the scenesdiscussion, is there some reasonwhy now might be the time to scrapindexation? And if so what will be theimpact on the inflation markets?Dr Deborah Cooper, a partner atglobal consultancy Mercer, told TotalDerivatives that the timing of there-emergence of this topic was asurprise, with little recent activity tosuggest that the government wasgiving the subject any particular thought.That said, Cooper noted “there is anongoing project at the DWP to look atsimplifying legislation that applies toDB schemes so it is bound to comeup from time to time.” Cooper warnedagainst assuming that because WebbThe biggest problemfor employers is whatto do about accruedbenefits. Governmentaction has madeaccrued rights prettymuch sacrosanct in theUK. Legislation makesthem hard to changewithout individualmember consent andit could be hard tochange the legislationretrospectively.has brought the subject up, it meansthat the government is on the brink ofdecisive action.The inflation linkage on DB pensionsused to match rises in RPI up to 5%.But some years ago the increase wascapped to 2.5% for benefits earnedafter April 6, 2005. That essentiallycreated a new mini-market in LPIderivatives, with a smaller LPI [0, 2.5]category joining the dominant LPI [0, 5].So what will the impact be on LPIand RPI derivative and gilt markets ifthe government has actually seen anopportunity to reduce some costs forUK PLC in the upcoming budget bypulling the safety net away for millionsof pensioners?According to Cooper, any impact islikely to be extremely limited. “Theinflation market is not big enough tohedge the existing indexed liabilities,there is massive demand for inflationlinkedproducts. It might just easesome of the [demand] pressure onthe market but the effect will be smallrelative to pressure already existingdue to accrued benefits.”Bob <strong>Scott</strong>, a partner at theconsultants LCP, agreed that it mightbe a mistake to get too excited aboutthe recent spate of indexation stories.He said that even if indexation wassuddenly dropped completely, “itwould only affect the future build-upof pension assets. At the momentthe private sector has more than£1trn of accrued benefits comparedto relatively small amounts of futureincrements. For example DB accrualsin the FTSE 100 run at about £5bn ayear, I doubt the national total is muchmore than £10bn a year.”And the chances of changes in theindexation status of accrued benefits ispretty much non-existent, says Cooper.“The biggest problem for employers iswhat to do about accrued benefits.Government action has made accruedrights pretty much sacrosanct in theUK. Legislation makes them hard tochange without individual memberconsent and it could be hard to changethe legislation retrospectively.”06 Q3 – Q4 2011
That said, Cooper contended that inprinciple at least, “accrued rights canbe altered without member consentprovided an actuary certifies thatthe value of the altered benefit is atleast equal to the value beforehandand trustees go through someextra compliance steps includingcommunicating with affected schememembers. This hasn’t happened sofar because indexation is compulsoryand so would still have to be provided.If indexation became voluntary, anindexed pension could be changedto a level pension, although of coursethe first payment of the level pensionwould have to be larger than the firstpayment of the indexed pension. So,if the government changed the needto index future accrual…it’s possiblesome schemes would go to the effortto alter scheme benefits, since it is somuch easier to hedge a level benefitthan an indexed one.”It seems probable though that thevast historical bulk of the definedbenefit pension market will remainindexed whatever happens, and willremain vastly more significant than anyindexation-free DB pension pool for avery long time.Despite the DWP’s hopes, as Coopersays, “Getting rid of the indexationon DB wouldn’t be enough of anincentive for employers to re-open DBpension schemes.”As for the possibility of companiesre-embracing DB pensions if theybecome detached from inflation,LCP’s <strong>Scott</strong> said that “On its ownit won’t make companies changetheir decisions about DB, and atthe moment [the story is based on]Pensions Minister Steve Webb floatingan idea and so I doubt it is of greatsignificance at the moment.”As for the inflation market, oneseasoned trader said that in LPIoptions, any link between a decisionon future indexation would “only havea very, very tenuous” impact on hismarket. “”There have been a numberof changes in the past. The cutfrom [0, 5] to [0, 2.5] for example,and they have made basically nodifference because of the size of theaccrued benefits.”Because of the accrued benefits,the trader said, “both RPI and LPIare unbalanced, and that isn’t goingto change for a while yet.” In themeantime, “every two months thereis a speculative newspaper storyabout indexation, I wouldn’t take ittoo seriously.”07 Q3 – Q4 2011
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