How high inflation has hit pensions and what it means long term

High inflation has hit members’ pensions benefits and pension scheme management for employers and trustees. Employers need to know where these factors interact and how best to navigate them.

1. Making the most of improved funding

Many pension schemes emerged from the Covid-19 pandemic in an underfunded state, where their commitments to members were higher than their ability to provide benefits.

However, with interest rates also rising to counteract inflation, some schemes have seen dramatic improvements in their funding levels. This has led to schemes approaching levels of funding that would allow buyout with an insurer much earlier than expected.

Unfortunately, due to the speed of the improvements, many schemes have been unable to capitalise on the enhanced funding levels that high interest rates have brought. It can take as long as five to seven years to get a scheme ready for buyout. Issues around data and benefits as well as illiquid asset structures mean underprepared schemes may find themselves unable to capitalise on early buyout opportunities.

Ensuring that a pension scheme is well governed is the best way to be ready for opportunities created by rapidly changing market conditions. It is important that the trustee board is engaged and well trained, as well as happy with the performance of their advisers.

2. Member communications in a volatile market

A pension is one of the most important rewards an employee will accrue during their career. But it can also be difficult to understand. It is important that scheme members are communicated with in a timely and effective manner so that they understand the impact of high inflation on their pension.

Many trustee boards choose to issue members with a yearly newsletter that provides them with updates on their pension scheme’s performance. As discussed, some schemes have seen dramatic increases in their funding level due to the increased interest rates that have accompanied high inflation.

However, trustees should be careful when communicating this to members. The schemes that have benefited most from high inflation were those that were underhedged. It is because of this that they are highly affected by interest rate movements and without steps to protect the improved position, funding levels could rapidly fall as interest rates decrease. As a result, members may be told in a yearly newsletter that a scheme is well funded only for this to no longer be true months later.

Members who see better funding can also have expectations of discretionary pension increases and this can lead to members being frustrated if they are denied them, as they hold different assumptions about the scheme’s ability to award these. To combat this, consider communicating with members more frequently when the market is volatile, or using more conservative language if member communication remains infrequent.

3. Helping members with retirement decisions

During periods of high inflation, there is plenty that benefits providers can do to support members and help them make good decisions for their retirement. It’s important to tell members how much their pension pot is actually worth as they reach retirement, helping them to avoid nasty shocks. Interest rates have been changing rapidly alongside inflation so, to remain current, it is essential that quotes on the value of members’ pensions go out within guarantee periods. Members should also be reminded to act on these in the appropriate timeframe, otherwise they may have to get a new quote.

High levels of inflation have affected the decisions that employees make around retirement and will continue to do so in the long term.

The higher interest rates that have come with inflation mean that transfer values for defined benefit scheme members have largely been lower. This reduction of value may lead to fewer members accessing their pension flexibility, with more employees phasing their retirement or delaying it entirely.

In the face of the cost-of-living crisis, fewer employees have been receptive to conversations about forgoing later pension increases that protect against inflation in return for a higher initial pension on retirement.

High inflation has hit pensions at all levels, from scheme funding to the individual choices that employees make. As the market continues to change rapidly, it is important that employers and trustees remain engaged to best support the needs of members and pension schemes.