Consultation on switch to CPI: Sackers’ Response
The DWP’s consultation, “The impact of using CPI as the measure of price increases on private sector occupational pension schemes” was published on 8 December 2010. The consultation followed the Coalition Government’s June 2010 budget which included an announcement that the Consumer Prices Index (CPI) would replace the Retail Prices Index (RPI) as the measure for applying increases (both for deferred pensions and pensions in payment) to public sector pensions. The Pensions Minister, Steve Webb, announced on 12 July 2010 that the change would also apply to private sector occupational pension arrangements.
In this response:
- Statutory increases
- Schemes which refer to RPI
- Administrative issues
- Section 67 issues
- Statutory override
- Communications with members
- Consultation with members
- CPI Underpin?
- Investment Issues
- Buy-outs / Buy-ins
Statutory increases under section 51 of the Pensions Act 1995 will automatically move to being based on CPI as it follows the Occupational Pensions (Revaluation) Order (the Revaluation Order) published each year. The 2010 Revaluation Order (also published on 8 December 2010) uses the CPI figures for statutory increases applied on or after 1 January 2011, for periods of revaluation from 1 January 2010. The Revaluation Order measures inflation over September-September in any year – for the year end 2010 CPI was 3.1% and RPI, 4.6%.
Where scheme rules refer explicitly to increases by reference to RPI, increases will continue being made by reference to RPI unless a scheme rule amendment is made. The Consultation does not include a statutory easement to make it easier to make amendments so there is a real risk section 67 of the Pensions Act 1995 will apply to any amendments. In practice this means the switch can only be made for future accrual. If the proposed requirements came into force, members will need to be consulted before any change is made.
If the trustees/employer decide to retain RPI, we understand from the consultation there will be no requirement for those schemes which use RPI for pensions in payment to change to CPI – making a CPI underpin unnecessary for most schemes.
The administrative issues surrounding the Government’s switch to CPI are complex. There are different statutory categories of increases – these include increases to pensions in payment, revaluation of pensions in deferment as well as the treatment of GMPs. These categories are then broken down into several different tranches, for example, on 6 April 2005, the cap on RPI for the purposes of the statutory requirement to increase pensions in payment earned after 5 April 1997 switched from 5% to 2.5% for pensionable service accrued on or after that date.
In addition to these statutory categories, schemes can, of course, provide their own (higher) level of increase. This means that, within a particular scheme, there may be multiple categories of members with different pension increase or revaluation rules, as a result of mergers, transfers or the establishment of new benefit sections.
Further, it is a common feature of definitive trust deeds and rules that they only apply to active members who are active during the period which that definitive deed is in force. For example, if this were the case the increase rules in a 1999 definitive deed may apply to a member who became deferred in 2008, shortly before a new definitive deed was entered into in 2009. The 2009 deed may therefore apply only to a limited group, if the scheme is not open to new members.
This means that, as well as different rules applying to different groups, even if a scheme’s rules currently apply the same index (i.e. RPI) to different categories of members, the manner of the proposed switch from RPI to CPI may have the effect that the change happens automatically for some members but not for others. For example, we have schemes where, the increase rule in the rules of the scheme prior to 2000 reflects the statutory requirement but, rather than referring to the statute, sets out the statutory requirement in “longhand” with explicit reference to RPI. In 2000, a definitive deed is executed, applying to active members only at the date of the deed, which aims to make the rules shorter or easier to read, and instead of setting out the statutory requirement in longhand, it simply refers to the statutory requirement (with no explicit reference to RPI). From the perspective of the drafter of the rules, this did not change the substance of the increase rule. However, the impact of the switch to CPI now is that a member who became deferred immediately before the date of the 2000 definitive deed will retain a right to increases by reference to RPI, whereas a member who became deferred immediately after the date of the 2000 definitive deed will only have a right to pension increases by reference to CPI (even though the periods of pensionable service of the respective members may have been almost identical).
Examples such as this highlight that trustees will need to closely examine the rules of their scheme over the entire history of the scheme (not just the current “definitive” documentation), and may find that the impact of the switch to CPI is arbitrarily different for different members depending on when they left the scheme when there was no intention that this should be so. Schemes that have had other schemes merged into them may find this complexity is multiplied many times over. The switch can therefore be potentially difficult for schemes to deal with, particularly for those which have experienced significant merger activity or have even, paradoxically, been updated regularly. It also creates the risk of members within schemes being treated differently and receiving different benefits, when the intention has always been that benefits should be the same.
In our view, given this level of complexity, even the Government’s revised impact assessment does not address the full cost to schemes of the change. Costs will be incurred by those schemes wishing to adopt the change where their rules make specific reference to RPI (and ensuring that the appropriate notifications are made to members). In addition, it is a common feature of administration agreements that where a change is being made other than for the purposes of complying with legislation, additional charges will be incurred for updating systems and processes. Consequently, schemes that wish to retain a link to RPI where the switch to CPI would be automatic in the absence of action may find they will bear an additional administrative cost.
We recognise that there is no simple solution for the significant complexities resulting from the Government’s switch to using CPI. However, the main objective should be to achieve certainty – for scheme members, trustees, administrators and others – while at the same time minimising the administrative burden. Given the many possible permutations for schemes, it would be helpful if the DWP were to make guidance available, setting out the practical impact of the change in different circumstances (and emphasising to schemes the need to check back through historic documentation).
Where scheme rules refer to RPI and trustees are asked to consider amending scheme rules to make the switch to CPI, they will need to take legal advice on section 67 to 67I of the Pensions Act 1995 (which protects members’ past service rights and entitlements). Section 67 to 67I applies (subject to limited exceptions) whenever a power to modify an occupational pension scheme is exercised so as to make a “regulated modification”. Essentially, “regulated modifications” are changes which would or might adversely affect a member’s or a beneficiary’s “subsisting rights”.
There is a real risk that a right to an increase at a specified rate would be a “subsisting right”. This is because the rate of increase is a “right which at any time has accrued to or in respect of him to future benefits under the scheme rules” under section 67A(6)(a)(ii). Although the increase has not been yet been granted the right to the increase accrued along with the benefits.
Again, it is our view that it is a modification which might adversely affect members benefits. This is because, although CPI has been higher than RPI in a number of instances, RPI has been consistently higher over the last 10 years (and more).
In addition, some scheme rules do not specify RPI but allow discretion to use a different definition of index e.g. “such index as the trustees specify from time to time”. Exercising such a discretion is probably within section 67. This is because although there is no amendment required to scheme rules, a modification for section 67 purposes is not limited to a change to rules. This view is backed by the pre-2006 case Aon v KPMG.
By analogy, we understand that the Government may have taken the view that section 67 applied when the cap dropped 5% to 2.5% in 2005 as that change was implemented for future pensionable service only.
Despite the problems relating to the making of amendments because of the restrictions imposed by section 67, the Consultation specifically states that the Government “does not propose to introduce legislation that would directly override the rules of occupational pension schemes without the consent of trustees or employers”. The Government believes that to do so would “represent unwarranted interference in the rights of employers and trustees”.
The Consultation recognises that the issues on whether to allow a statutory easement are “finely balanced”, but states that the Government does not propose to introduce a section 68 modification power to allow schemes to use CPI. This is because it considers “members’ trust in schemes and the scheme rules could be severely damaged if it intervenes to give schemes the power to change the rules”.
Section 68 enables trustees to make amendments by resolution. It is considered helpful where a scheme’s own amendment power places obstacles in the way of trustees making certain specified changes to scheme rules. However, it should be noted that we believe trustees may still hesitate to use this route as, in the words of the Consultation, they “may find it difficult to reconcile using such a power with their fiduciary duties.”
Another issue for employers and trustees to consider when looking at implementing a change is what communications to members have said. Where booklets (or other communications to members, such as leavers’ statements) state that increases are to be provided at, for example, RPI but this conflicts with the position under the rules which specify statutory increases, the rules will normally prevail. A well crafted pension scheme booklet, containing a specific provision that in case of conflict the rules override the booklet will normally not be binding – see ITN v Ward and Steria v Hutchison.
Where there is no specific provision providing that the rules will override, the same principles apply to increases as to other benefits. So, unless a contract has been formed by the document outside the scheme rules – which is unlikely, a member will only be entitled to the higher rate provided they can run an estoppel argument (such as the one that succeeded in Catchpole) or could run a change of position defence (as formulated in Lipkin Gorman). Estoppel is notoriously difficult to demonstrate. And a change of position defence is also unlikely to be accepted, given the right is to future increases.
For schemes looking at making changes, the Consultation proposes introducing a new “listed change”, meaning that changes to revaluation and indexation rules would need to meet the employer consultation requirements, (The Occupational and Personal Pension Schemes (Consultation by Employers and Miscellaneous Amendment) Regulations 2006). Although the introduction of a requirement to consult adds an additional layer of complexity, we have no major concerns with this approach. However, in the proposed draft legislation we query the use of the word “rate” and suggest this should instead read “index”, as “rate” would catch the 2005 change to the cap from 5% to 2.5% (but not, we suspect, the switch from RPI to CPI).
We note that the Consultation (and now the Pensions Bill) does not require schemes which have RPI written into scheme rules to provide a CPI underpin for pensions in payment, provided certain conditions are met.
There had been speculation that an underpin would be required for increases to protect pensions in any years where CPI exceeds RPI. This stemmed from the fact that, although the switch to CPI is likely to lead to lower increases for pensions in the longer term, there have been several instances in the last few years where CPI was higher than RPI.
The Consultation makes it clear that the “Government proposes to take action so that any scheme choosing to stick with RPI increases would not have to pay the increase at the higher of CPI or RPI in any given year”. The Government has justified this on the basis that as RPI is expected to be higher than CPI, members would be generally better off and applying an underpin would increase liabilities in schemes. We believe that the requirement not to have a underpin in such cases is very helpful.
However, the Pensions Bill, clause 14(5), (which inserts a new section 51(4)), applies a proviso to this easement. If a scheme currently uses the scheme opt-out method under section 51, and therefore uses RPI to increase pensions in payment (rather than the statutory route) it will be able to avoid having an underpin, only if “the rules require, and since the relevant time have always required” an increase by reference to RPI. The relevant time is uncharacteristically vague for legislation – specified as “the beginning of 2011” for pensions in payment before 2011. For pensions not yet in payment, the relevant time is whenever they come into payment. It would be helpful if this 2011 date could be tied down, perhaps to the date of commencement of this clause (otherwise we see the potential for discussion concerning the intention of this clause and it would seem that pensions coming into payment between the start of 2011 and this clause coming into effect may not be covered).
A problem is that some scheme rules do not specify RPI but, for instance, either:
- use a different definition of index, for example, “such index as the trustees specify from time to time”;
- intend to specify RPI (and the trustees use RPI) but in practice use other wording, such as “the Government’s Price Inflation Index”; or
- are silent, but in practice the trustees have always used RPI.
In these cases it is likely, based on the current version of the Pensions Bill, that a CPI underpin will be required. We would be grateful if you could confirm this is the intention.
We note that there appears to be no intention to make legislative changes to that no CPI underpin will be required where RPI is promised for revaluation in deferment (and for increases to GMPs). We would argue that there is a good case for treating this group as for pensions in payment, both to ensure fairness of outcome and to make administration easier.
As part of the calculation of CETVs an actuary must take into account “a member’s accrued benefits, options and discretionary benefits” . Therefore, an allowance must be made for increases.
Obviously it is only necessary to allow for the increases that the member is actually entitled to:
(a) Scheme rules which specify RPI: if scheme rules specify RPI for revaluation, RPI will need to be provided, unless the rules are amended to refer to CPI (and if it is possible to make the change);
(b) Statutory increases: if the scheme specifies that the statutory method applies, we consider that it is reasonable to assume for the purpose of calculating CETVs, that if the scheme uses the statutory method of revaluation, deferred pensions would be revalued by reference to CPI rather than RPI. It would be helpful to include in the guidance on transfers, that the actuary in such a case makes the assumption that future revaluation orders will be based on CPI. At present only the 12 July 2010 DWP announcement expressly references future Revaluation Orders.
The change from RPI to CPI increases may also affect investment arrangements. At the moment many schemes use index-linked gilts and swaps to manage inflation risk. But all available hedging investments are RPI not CPI linked. It remains to be seen how quickly CPI linked instruments will develop.
There is as yet no market in CPI linked investments. The Debt Management Office has indicated that it does not intend to issue CPI linked gilts in the near future but will keep it under review. It would in theory be possible to do a CPI-linked swap – as swaps are bilateral it is possible to negotiate what you want – but from what we understand:
(a) swap providers are not keen; and
(b) it would at the moment be (at least) as expensive as RPI because there is no market for swap providers to enter into an onward hedge of the risk they are taking on.
However, we do not have any evidence that pension schemes are agitating to hedge the risk, so it may be some time before a market emerges.
Buy-outs / Buy-ins
Buy-outs and buy-ins are both forms of contract for securing benefits through an insurance company. As the Government has noted, “the impact of using CPI for statutory indexation and revaluation will not directly interfere with any existing contracts”.
However, many existing contracts will have been negotiated with increases and/or revaluation referenced to RPI even if the scheme rules provided only a link to statutory requirements. Some schemes may wish to renegotiate existing contracts but may find this difficult.
- Buy-outs: our experience is that it is generally too late to renegotiate;
- Buy-ins: the likelihood is that schemes which have entered into buy-in contracts have paid for RPI and that is what they will get (subject to the policy terms). Providers are generally open to adjusting benefits but because there is no market in CPI hedging instruments will not offer attractive voluntary terms for adjusting from RPI to CPI – i.e. you are unlikely to get much of a retrospective price reduction.
The same issues apply to annuities purchased for an individual. In general, if increases are referenced by RPI these will be written into the contract.