Understanding Limited Price Indexation in Pensions

Limited price indexation in pensions is a concept that can be a bit tricky to understand, but it's essential to grasp if you're approaching retirement age.

In a limited price indexation system, the annual increase in pension payments is capped at a certain percentage, such as 3%.

This cap helps to prevent pension payments from growing too quickly, which can lead to inflation.

Pensioners who rely on their pension payments for their living expenses may appreciate this cap, as it ensures their purchasing power is protected.

However, this cap may not keep pace with the rising cost of living, which can leave pensioners struggling to make ends meet.

In some countries, the cap is adjusted annually to reflect the rate of inflation, but this can still leave pensioners facing a squeeze.

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RPI is not always the best measure of inflation, as acknowledged by the Office for National Statistics (ONS) in Atos IT Services UK Ltd v Atos Pensions Schemes Ltd.

The ONS has preferred the use of a different measure, but the High Court held that RPI still means RPI as long as it's published by the UK Statistics Authority, even if it's not a good measure of inflation.

In some cases, RPI has been materially altered, which can affect its use as an inflation measure. For example, in Thales UK v Thales Pension Trustees, the introduction of the house prices index into RPI was deemed a material change.

The High Court agreed that the principal employer, with the agreement of the trustees, could determine the nearest alternative index to use in such cases. However, in Thales' case, the nearest alternative was RPI as materially changed, not CPI.

It's not up to the employer to decide whether RPI has become an inappropriate measure, as the Court held in British Telecom v BT Pension Scheme Trustees. An objective test is applied to determine whether RPI has become inappropriate, which is a fact-sensitive and evaluative judgment.

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Index composition changes can significantly impact the calculation of pension increases. The Thales UK v Thales Pension Trustees case [2017] highlights the importance of considering material changes to the index used.

The governing documentation of the CARE section of the pension scheme in Thales UK specified that if the Government retail prices index for all items is not published or its compilation is materially changed, the Principal Employer, with the agreement of the Trustees, will determine the nearest alternative index to be applied.

In the Thales UK case, the High Court agreed that RPI had been materially altered due to the introduction of the house prices index into RPI.

The High Court determined that the nearest alternative to RPI was not CPI, but RPI as materially changed. Although RPI had materially changed, due to the specific wording of the Thales scheme rules, RPI remained the appropriate Index.

A further judgment in the Thales case in April 2020 resulted in the switch to CPI being unwound.

The High Court agreed with the Pensions Ombudsman that the ordinary and natural meaning of the provision was that the rate of pension increases should be RPI. This meant that affected members were put back where they would have been, with interest.

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In the case of Thales UK v Thales Pension Trustees, the High Court agreed that RPI had been materially altered due to the introduction of the house prices index into RPI.

A different index can be used if the original one is materially altered, but the specific wording of the scheme rules must be considered. The Thales scheme rules stated that RPI remained the appropriate index, despite its material alteration.

The High Court also considered a case where the revaluation order under the Pension Schemes Act 1993 specified RPI, but was later changed to CPI. The Court ultimately decided that the rate of pension increases should be RPI, and that the switch to CPI had to be unwound.

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Living cost indices can serve different purposes, as seen in the Thales UK v Thales Pension Trustees case. The governing documentation of the CARE section of the pension scheme allowed for a different index to be used if RPI was not published or its compilation was materially changed.

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In this case, the High Court agreed that RPI had been materially altered by the introduction of the house prices index into RPI. The principal employer, with the agreement of the trustees, could determine the nearest alternative index to be applied.

The nearest alternative to RPI was determined to be RPI as materially changed, not CPI. This shows that even if an index is altered, it can still serve the same purpose.

The Thales scheme increase rules also illustrate this point. The rules stated that the percentage increase in RPI should be used, subject to a maximum of 5 per cent. However, the revaluation order under the Pension Schemes Act 1993 referred to CPI from 2010 onwards.

The High Court ultimately agreed that the rate of pension increases should be RPI, meaning that the switch to CPI had to be unwound. This means that even if an index is changed, it can still be used for its original purpose if specified in the governing documentation.

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A swap is a financial instrument that allows two parties to exchange different types of payments.

In the context of alternative indices, a swap can be used to manage inflation risk, as seen in the Limited-Price Indexation Swap. This type of swap involves exchanging a fixed amount for the limited-price indexation (LPI) return over the life of the swap.

The LPI is a UK inflation index used to define typical payout structures of UK pension schemes. Historically, the cap and floor were set at 5% and 0%, respectively, but more recently they are set at 3% and 1%.

Pension schemes often enter into contracts with a cap/floor collar on year-on-year inflation growth, receiving collared inflation-linked payments in exchange for an annual fixed sum.

In the UK, many pension liabilities are inflation-linked, making swaps like the Limited-Price Indexation Swap a useful tool for managing these risks.

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