A period of negative inflation could increase the real value of some defined benefit (DB) pension schemes, although sponsoring companies would suffer, says Watson Wyatt.

The financial consultant has spoken out following the first episode of negative RPI inflation over 12 months in the last 49 years, and believes it unlikely that inflation-linked payments to retirees of DB pensions will be cut.

However, trustees could be subject to legal issues when it comes to working out how their scheme rules should be applied should they choose to use the negative inflation to offset part of the effects of rising inflation next year.

Rash Bhabra, head of corporate consulting at Watson Wyatt, explained: "If prices fall and pensions stay the same, pensions go up in real terms. That's good news for pensioners, but the cost will fall on employers who are having enough difficulty with their pension deficits as it is. In general, it is only people already drawing their pensions who stand to gain. If you have stopped working for the scheme sponsor but not yet retired, your pension will be increased in line with inflation over the whole period until you start collecting it, so a short period of deflation will not usually affect the real value of the pension you receive in retirement."

He added that if scheme rules allow for one year's deflation to cancel out the following year's increases, "cost-conscious employers will not rush to pay for increases that do not have to be give. Trustees may also question whether awarding pension increases above those required by the rules is fair on younger members, particularly if the scheme has a big deficit."

Watson Wyatt concluded that the member could onto a winner if negative inflation is immediately followed by inflation above a capped level, as extending the period over which statutory increases can be measured would increase the maximum increase that could be due in any one year.

However, David Everett, partner at Lane Clark & Peacock LLP and head of pensions research, is concerned that this positivity may only be temporary. "Just by standing still, pensioners could be set to enjoy 'above inflation' pension increases over the course of 2009. This was not contemplated when the legislation governing pension increases was set by the Government a number of years ago. Whilst allowing schemes to increase pensions in payment to reflect inflation, the law does not enable schemes to reduce pensions in payment to reflect deflation.

"But the situation is different for deferred pensioners. Periods of deflation can be taken into account in revaluing pension benefits up until retirement so long as prices in this period increase overall. And for active members, the prospect of low pay settlements and the reality of cuts in pay for some, could feed through to a reduction in expectations for pension rights already accrued."

- Pensions Age April 2009

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