Managing Your Money 

The future of final salary

If you're one of those lucky enough to be in a final-salary pension scheme, also known as the gold-plated version of UK pensions, you are in for some bad news. The government's announcement that there will be a move from using the Retail Price Index (RPI) to the Consumer Price Index (CPI) to revalue and increase final-salary pensions will see up to 12m scheme members end up with a significantly smaller pension.

RPI vs CPI
RPI and CPI are measures of UK domestic inflation which are calculated by collecting a sample of prices for a selection of representative goods and services in a range of UK retail locations. One of the major differences between the two indices is that RPI includes mortgage interest costs but CPI does not, so usually RPI inflation is higher than CPI meaning that when pensions revalue using CPI rather than RPI, their value will increase by less. Since 1988 RPI has averaged at 3.6 per cent while CPI has averaged at 2.8 per cent.

The impact

Over the longer-term you can expect CPI to be on average 0.5 per cent lower than RPI, according to John Broome Saunders, actuarial director at BDO. "Half a per cent doesn't sound like much to get excited about, but over the lifetime of a typical pension fund - perhaps 40 or 50 years - it makes a significant difference," he says.

People with preserved pensions - ones with a former employer that you have stopped topping up but are not yet drawing - will also be affected because these have been revalued each year in line with RPI, but will now rise in line with CPI. The change from RPI to CPI will also impinge on pre-retirees with preserved pensions, who do have exposure to mortgage interest costs.

The longer you have until retirement the worse the effect on your savings because your pension is revalued by less until retirement - as well as being increased by less after retirement. Research from pensions experts at Hargreaves Lansdown shows that, for instance, a 40-year old with a £5,000 preserved final-salary pension today could have expected to receive a pension of £11,603 from age 65 if uprated in line with RPI, but with CPI uprating this would only be £9,769. The CPI uprating continues once the pension is in payment so by 85 the pensioner could be receiving an income of £17,070 compared with £23,403 if it had been uprated by RPI. In the course of the 20 years over which the pension is paid the pensioner loses £77,077.

The change is also bad for a pensioner retiring now, according to Hargreaves Lansdown's figures. Based on historic rates of RPI and CPI a pensioner retiring on a £5,000 final-salary pension could expect an income of £9,737 in 20 years if it is uprated in line with RPI. However, if it is uprated in line with CPI it will only be worth £8,497 - 13 per cent less. Over that 20 year period, the pensioner will miss out on £10,367 income. The longer the pensioner lives - the worse the impact will be.

The government's argument is that CPI is a better measure of pensioner inflation because it does not include mortgages, which many people have paid off by retirement. But Laith Khalaf, pensions analyst at Hargreaves Lansdown, argues that this measure also does not include council tax which accounts for a higher proportion of pensioners' expenditure than for those at working age. The Office for National Statistics says that council tax accounts on average for 7 per cent of the expenditure of those aged over 75, but only 3 per cent for those under 50.

"In truth neither CPI nor RPI is a pinpoint measure of pensioner inflation which is disproportionately affected by increases in food, energy bills and council tax," says Mr Khalaf. See table below for the spending patterns of different age groups.

Spending patterns of different age groups across different categories

Age groupFoodElectricityGasPetrolClothing/footwear
Under 309.70%2.10%1.80%4.90%6.50%
30-4911.40%2.10%1.90%5.70%6%
50-6411.70%2.30%2%6.10%5.50%
65-7414.70%2.70%2.40%4.70%4.10%
75 and over17.30%4%3.70%2.90%4.20%

Source: Alliance Trust

What to do?

The good news for some savers is that their final-salary schemes are bound to link to RPI by their rules, so first of all check with your employers if this is the case, although it is only likely to apply in a few cases. "It is not yet clear whether Steve Webb, the pensions minister, intends to introduce legislation to allow these schemes to make a retrospective change to CPI," says Mr Broome Saunders, so you should keep tabs on government announcements regarding this even if your scheme has RPI written into its rules.

If your scheme is switching to CPI then you need to be prepared to save more. "The straightforward strategy is going to be that final salary pension scheme members are going to have to build a bigger retirement pot to cushion themselves against the longer term impact of inflation," says Nick Bamford, chief executive of financial advisers Informed Choice.

Mr Khalaf suggests either topping up your workplace pension or saving into a private pension, such as a self-invested personal pension (Sipp) in addition to your employer's scheme. "If you are still some way from retirement see if you can save more into your final-salary scheme, but unfortunately most employers won't allow this so realistically you should look to a private savings vehicle such as a private pension," says Mr Khalaf.

The advantage of a Sipp is that it allows you to take control of the long-term planning of the funds invested in it, with more flexibility in terms of the investments you choose. You could also save into an individual savings account (Isa), or use a combination of pension and Isa. "Sipps and Isas can be complimentary as long-term retirement planning vehicles," says Stephen Barber, adviser on economics and markets at brokers Selftrade. "What you draw from an Isa at retirement does not incur tax, which is not the case with pensions."

Advisers do not recommend investing your private pension or Isa into inflation-linked investments, as generally the returns on these are not very good. "Inflation-linked products are only really attractive when you get inflation, or if you anticipate high inflation in future," adds Dr Barber.

Should you get out?

Mr Khalaf says that you should stick with your final-salary scheme if you have one. "It is possible to move from a final-salary scheme to a defined-contribution (DC) scheme but in most cases it is unwise. It is very rare to find a DC scheme which is better so if you have a final-salary scheme stick with it - it is still a pretty good benefit. Even with reduced income final salary schemes are usually better than DC ones."

"Once you are in the DC scheme you have to the fund inflation proofing of your pension your self," adds Mr Bamford. "This is very expensive and probably why the government has made the changes in any event. This demonstrates that to build a suitable retirement fund and protect it against inflation is very expensive."

If you are already retired, and do not need all the income you are drawing from your pension, Mr Khalaf suggests you save into an Isa or a National Savings & Investments (NS&I) product, which are also tax efficient.

Defined benefit vs defined contribution

With a final-salary scheme, also known as a defined-benefit scheme, the amount of income an employee receives on retirement is defined in advance, based on the number of years they have worked for an employer and the level of their salary when they retire.

In the case of a defined-contribution pension, the contributions are specified but the amount received by the employee on retirement is not fixed. Instead, it relates to how the funds in the plan have been invested and the return on that investment. The employee carries the investment risk, and the inflation risk whereas with a final-salary scheme this lies with the employer.

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