The impact of inflation on pension sharing reports

close-up of a woman’s hand using a calculator

With the announcement last week that the eurozone has slipped into recession, we have seen yet more headlines about the causes and challenges of high inflation (mainly driven by rising food and energy prices).

For any of you who watched our last round of webinars, one of the more common questions we have been receiving lately is: “What impact is higher inflation having on divorce settlements?”

We have seen the Bank of England (BoE) raising interest rates to try and combat high inflation, and the current economic climate is now vastly different to that of 18 months ago.

This change in economic conditions has manifested itself in two key areas. The first is the impact on cash equivalent values of defined benefit (DB) schemes. The second is how the impact of high inflation should be considered in pension sharing reports.

Read on for more analysis of the second of these issues.

What’s the current situation?

At the heart of the matter are the annuity rates that Pension on Divorce Experts (PODEs) are using in their calculations.

From our “shadow expert” work, we see reports from many different PODEs. We see that most PODEs are comparing income drawn from a defined benefit (DB) pension scheme with an inflation-linked annuity (typically capped at 5% a year) when purchased by a DC scheme.

It is important to note here that a significant number of private sector DB schemes will have a cap on the annual inflationary increases payable by the scheme. Using an inflation-linked annuity when comparing scheme benefits replicates the income from a DB pension in a more honest way than, for example, a fixed (level) annuity.

As inflation changes, the income received increases to preserve the purchasing power of the pension.

As an aside, it is important to note that a person in receipt of a public sector pension (for example, the NHS or Armed Forces scheme), will be subject to an annual increase based on the Consumer Prices Index (CPI) as laid down by HM Treasury every year. This is applied at the beginning of April.

The increase in April 2023 was 10.1%, and there is no upper or lower cap on the increase that can be applied.

Why does this matter?

As discussed in the Pensions Advisory Group (PAG) report, it is important to factor in equality of risk, and where feasible, equality of income profile, when seeking to achieve equality of income.

What does this mean?

Our calculations endeavour to equalise guaranteed incomes at a specified age, and for the incomes to increase in broadly the same way going forward (matching income profiles).

While it may be better value for the transferor to have a share calculated on either a level annuity basis (non-increasing), or one with a fixed increase (for example, 2.5% a year), this would not seem equitable.

For obvious reasons, a level annuity would not be appropriate, and using an annuity with fixed increases gives an individual no protection against inflation above 2.5%.

In this regard, it is a different product from an index-linked annuity, which we feel is more appropriate for these purposes in giving full protection against inflation.

The eagle-eyed among you will know that most public sector schemes will increase by CPI, whereas we would usually recommend using a Retail Prices Index (RPI) linked annuity.

As mentioned above, equalising pension income and equalising indexation of the income often represents a challenge to the PODE. The answer is a simple one of practicality: CPI-linked annuity rates are not available on the open market, and so we believe that RPI-linked annuity rates are the most appropriate to use for comparative purposes.

Are we changing our assumptions to reflect the current high level of inflation?

All the assumptions made in our reports are considered by our investment committee on a regular basis.

While the current level of inflation is significantly higher than we have seen for some time, our future inflation expectations are in line with the long term forecasts set by the BoE.

Get in touch

As always, if you have any questions, please reach out. Email or call us on 0118 987 6655.

Please note

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.