Will YOUR pension rise with inflation, see increases capped or be frozen?

Tom Selby is head of retirement policy at AJ Bell.

Soaring inflation affects everyone, including those in receipt of a pension income.

Not all pensions are made equal, however, and some – most notably people with public sector pensions – benefit from generous and uncapped inflation protection.

State pensions are also set to rise substantially next year, with all eyes on September’s inflation figure, which is traditionally used to uprate benefits the following year, whenever it is higher than average earnings growth or 2.5 per cent.

If by next month inflation has reached the Bank of England’s forecast 13 per cent, the new state pension would breach £200 a week for the first time, hitting the Exchequer with an estimated £13billion bill.

So what do rising prices mean for people with different types of pension, and retired people facing a cost of living crisis.

Drawdown plan: Don’t stick your head in the sand

Anyone using an invest-and-drawdown plan to fund their retirement needs to think carefully about how they respond to rising prices.

The good news is that you’re in complete control, thanks to flexible pension reforms that allow savers to choose exactly how they use their pension.

However, that also means it is up to you to ensure those savings last throughout your retirement.

The natural thing to do in response to rising living costs might be to take more income from your pot to maintain your standard of living, but this increases the risk of your fund running out early.

This risk will be further exacerbated if larger withdrawals are combined with substantial market falls – something many have already experienced in 2022.

This isn’t a reason to panic, but retirement investors must not stick their heads in the sand either. 

Think carefully before increasing your withdrawals and make sure you have considered the impact that decision could have, ideally with the help of a financial adviser.

Our customer research suggests investors are taking a mixed approach, with 60 per cent keeping withdrawals the same, while 24 per cent are cutting back withdrawals in the face of market uncertainty and 16 per cent are increasing withdrawals.

All of these actions may be perfectly sensible depending on the person’s circumstances.

State pension: Could top £200 a week from next April

The ‘basic’ state pension and the ‘new’ state pension both benefit from the triple-lock guarantee, meaning they increase by the highest of average earnings, inflation or 2.5 per cent.

The inflation part of the triple-lock will almost certainly apply for the 2023 increase, assuming the triple-lock is retained.

The now former Chancellor, Rishi Sunak, temporarily suspended the triple-lock due to an unforeseen year-on-year spike in wage growth in 2021 after the pandemic supressed wages in 2020.

Nonetheless, it would be extremely divisive to break the triple-lock pledge again on the basis of an unexpected rise in inflation – particularly with a general election on the horizon.

Currently, the basic state pension is worth £141.85 per week (£7,376.20 per year), while the new state pension pays £185.15 per week (£9,627.80 per year).

If inflation in September hits 13 per cent, this implies the basic state pension would rise by £18.45 to £160.30 per week (£8,335.60 per year), while the new state pension would rise by £24.10 to £209.25 per week (£10,881 per year).

Other pensioner-related benefits – pension credit and additional state pension (which applies to state pensions for those who reached state pension age before April 2016) – and working-age benefits also usually rise in line with September’s inflation figure.

The cost of increasing the state pension by 13 per cent would be astronomical, with each 1 percentage point rise costing roughly £1billion. And that is not a one-off cost either.

The inflationary increases are baked in so state pension costs will be significantly more expensive going forward.

Annuities: Most are not inflation linked

Annuities lock in a retirement income for life. This provides extra certainty but limits flexibility and extinguishes the possibility of generating further investment growth.

The impact of high inflation on those who have already bought annuities will depend on the type that was bought.

Some will have inflation protection baked into the terms of the contract, although this is often capped.

If inflation exceeds the cap – which it will for many people this year – then your income will actually fall in real terms. This will no doubt anger people that purchased what they hoped would be an inflation-proofed income.

However, most people (historically at least) have bought annuities with no inflation protection, meaning they risk being brutally exposed to surging prices.

In the 2020/21 tax year around 85 per cent of the 60,000 annuities purchased were ‘level-only’, meaning they had no inflation protection at all. Just 15 per cent of annuities bought were ‘escalating’, meaning they rise with inflation.

Inflation: Public sector pensions and the state pension – providing the triple lock is reinstated – have guaranteed protection

Public sector defined benefit pensions: Inflation protection guaranteed

Defined benefit – also known as final salary – pensions provide a guaranteed income for life similar to annuities, except this time the promise is underwritten by the employer.

In the case of public sector pensions, that employer is the state, meaning pensions are essentially underwritten by taxpayers.

It means former public sector employees can expect to see their pension income rise by as much as 13 per cent next year, depending on September’s inflation figure.

There is a broad cost control mechanism that could see public sector pensions tightened in other areas – for example by raising retirement age or increasing contribution rates – in order to avoid the burden on taxpayers spiralling completely out of control.

Private sector defined benefit pensions: Increases will be capped

The impact of inflation on private sector defined benefit pensions will depend on the rules underpinning the scheme.

Often these rules will place a cap on inflation protection, meaning they won’t enjoy the same increases as their peers that worked in the public sector.

This pension apartheid will rankle former private sector workers that see their spending power diminished.

Some schemes still use RPI as the measure of inflation against which to uprate pension payments. As things stand RPI is a whopping 12.3 per cent, and typically runs higher than CPI.

It could have meant private sector defined benefit scheme members received an incredible CPI-busting increase, but that will be quashed if schemes apply the 5 per cent and 2.5 per cent caps typically available to them.

If you have this type of pension, it is worth checking what the cap is in its rules, or giving your scheme a ring.

UK plc will no doubt be grateful for the option to apply a cap, since firms with a liability to former employees could otherwise face needing to top-up their pension scheme, potentially hindering investment in the business.

Cost of living: The Bank of England has forecast the headline CPI rate of inflation will top 13 per cent this autumn

Pension Protection Fund: Inflation linked rise capped at 2.5%

When private sector defined benefit schemes go bust, the Pension Protection Fund is responsible for paying out members’ pensions.

If the UK enters recession, it is likely more schemes and their members will join the PPF if their parent companies are forced under.

The inflation protection you might from receive from the PPF varies depending on the period of time during which you built up the benefits.

In most cases payments relating to pensionable service from 6 April 1997 onward will rise in line with inflation each year, but subject to a cap of 2.5 per cent a year.

At current inflation rates that means PPF members will be experiencing significant real terms cuts in their benefits. 

Lifetime allowance: Frozen before inflation took off

The lifetime allowance is how much you can save into a pension and get tax relief on in total.

It is supposed to rise in line with CPI inflation every year but in the spring 2021 Budget the Government cancelled these increases until 2025/26. As a result, the lifetime allowance will remain frozen at £1,073,100 for the rest of this Parliament.

The annual allowance is £40,000, and is the standard amount you can put in your pension every year and qualify for tax relief – including your own and your employer’s contributions, and the tax relief itself.

Higher earners have a tapered annual allowance, which means it is reduced down to £10,000, and top earners see it tapered down to £4,000.

The money purchase annual allowance, which is £4,000 a year, is how much you can put in a pension and still get tax relief on after you start making pension withdrawals over and above your 25 per cent tax free lump sum. 

Still saving for retirement: Keep up your contributions if you can

With inflation ripping through the UK economy and households braced for another eye watering rise in energy bills in the autumn, millions of people will be revisiting their budgets and looking for ways to save a bit of extra cash.

Given the challenging nature of this backdrop, it is inevitable some will be considering cutting back pension contributions, or even stopping saving for retirement altogether.

It’s important anyone considering going down this road is clear on what they are missing out on. If you opt out of your workplace pension scheme, you are essentially giving up your matched employer contribution – effectively a voluntary pay cut.

Furthermore, you will miss out on the upfront boost provided by pension tax relief.

If you opt out of your workplace pension scheme then your employer is required to re-enrol you after three years.

However, the loss of compound growth means that three-year gap alone could result in your pension being much smaller at state pension age.

Those who feel they have no choice but to quit their workplace pension should have a plan to get back on the retirement savings horse as soon as possible.