In speaking out in favour of ending mandatory inflation proofing, pensions minister Steve Webb recently aired an idea that has been touted for years as a way to revive the ever dwindling fortunes of defined benefit schemes

The pensions industry has welcomed Webb's call. Many fear though that any proposal to scrap enforced inflation guarantees amounts to too little, too late, to herald a return to a time when all major companies would offer a defined benefit (DB) scheme.

The cost of defined benefit plans to companies has simply become too much for them to bear, with no FTSE 100 company to offer a final salary pension option to new staff from next year (when Shell has said it will close its scheme).

Guaranteed increases to benefits to compensate for inflation are one of several pieces of regulation introduced over the last 20 years that people blame, along with sluggish investment returns, for the demise of DB in that period.

The Pensions Corporation, which insures companies from the financial risk associated with DB schemes, estimate that mandatory inflation guarantees, which were introduced in 1995, have made final salary plans 12% more expensive.

Rough calculations suggest that eliminating this guarantee would be enough to wipe out most of Britain's combined £255.2bn occupational pension deficit.

David Collinson, the Pension Corporation's head of business origination, who calculated the figures, told Pension Funds Insider that he supports scrapping the guarantee. Nonetheless he can't see that move "causing a sea change" in the continued erosion of defined benefit pension rights.

Speaking on what went wrong with the idea of inflation guarantees, Collinson explained "needing to promise and guarantee inflation increases has quite a high cost and has needed the backing of risk-free investments. That in turn has reduced investment returns by 3% per annum."

Collinson says that "the legislation was all designed to protect pensions but it has only protected a minority. There has been a law of unintended consequences for the 1995 Pensions Act in trying to protect pensions has led to a dramatic overall reduction in pension provision."

Collinson drew parallels with the Netherlands to explain how inflation guarantees have proved counter-productive in their intentions to support DB pension saving in the UK. He said "Dutch pension funds offer an intention of inflation increases which isn't guaranteed beyond maintaining benefits at their current level. The Dutch funds all look better off than the UK funds as they have this release valve in that if things go badly wrong they don't have to offer an increase."

Raj Mody, partner and head of PwC's pensions practice also said that while removing the inflation guarantees would help to make providing a DB pension easier, the effect would be minimal compared to the havoc that the measure made when introduced.

Saying that inflation guarantees had proved to be a "pyrrhic victory", Mody said that "scrapping indexation for defined benefit schemes is of course going to be regarded as a removal of benefits but it's worth remembering that most employers never chose to provide these increases in the first place."

He continued by saying that "successive governments have introduced various index linked measures to boost defined benefit pension incomes. If employers had known these changes were coming, they'd have probably set the base level of pensions much lower from the outset."

Back from the DB brink

Collinson argued that "the more restrictions that you can take off the provision of a defined benefit pension the less likely it is that the final few companies still offering the schemes will stop them. If you are a director though, starting with a blank sheet of paper now and wondering whether to provide a 70 or 80 year guarantee to tour workforce, the answer is probably not."

Collinson said that anyone offered the chance to save in a defined benefit scheme without inflation protection would still be inclined to use it given that defined contribution schemes are riskier and generally less generous. He said that "if you are being offered a DB scheme that your employer will pay into it has got to be attractive."

Martin Scott, partner of legal firm Mayer Brown, meanwhile told Pension Funds Insider that any attempt to remove the inflation guarantee could entangle pension funds in legal claims. That is what has happened in the past year or so since the government allowed schemes to change their inflation guarantees for benefit increases from being tied to the Retail Prices Index (RPI) to the less generous Consumer Prices Index (CPI).

Scott said that any pension fund wanting to scrap inflation guarantees may well find that they have them embedded in the scheme rules and that they would need to get trustees to take them out. So there "would be plenty of interesting issues as to how scrapping inflation guarantees would apply in practice to existing scheme members."

As the vast majority of defined benefit schemes are closed to new members, Scott pointed out that the change, if carried out, will have no impact on most DB savers "and by the time it happens there will be even more people in closed DB schemes".

"Nonetheless, every little helps", Scott added.

The Department of Works and Pensions has made it clear that however the idea develops, pensions accrued up to now will be protected. A spokesman added to press that no decisions have been made yet on the idea.

dbillingham@wilmington.co.uk