Inflation: the good and bad news for pensioners

Pensions look set to rise by nearly £3 a week from next April, but it could have been more if the old system had been in operation.

The latest inflation figures – published this morning by the Office for National Statistics – showed an annual rate of 2.7 per cent in September. This is particularly significant for millions of people because it is used to uprate the basic state pension, as well as other benefits, from next April.

The basic state pension for a single pensioner is currenly £110.15 a week. Uprating this by 2.7 per cent will mean an increase of £2.97 a week, taking the total to £113.12.

Technically, the final decision has to be taken by the Work and Pensions Secretary, Iain Duncan Smith, and it will be announced in parliament towards the end of this year.

If the RPI measure had been used to uprate inflation over the last three years, the state pension would £1.09 a week higher from next April than under the CPI system – a difference of £56.68 a year

But pensions – and the amount they go up by – are such a political hot potato that it seems unlikely the government will do anything other than use this rate to determine the increase.

Triple lock

When the coalition came to power, it made great play of its commitment to protecting the basic state pension through what it called the “triple lock”. This meant the pension would go up by whichever was the highest of three measures: inflation, average earnings or 2.5 per cent.

We will get the latest average earnings figures on Wednesday, but as of last month, they were rising at an annual rate of about 1 per cent, so unless there is an enormous surprise, 2.7 per cent is the rate that will be used.

This is good news for pensioners to the extent that inflation is still rising faster than earnings, so their financial position is improving relative to those in work. But the increase could have been larger if the old system for determining pensions was still in place.

The coalition decided at the time of the emergency budget in the summer of 2010 that it would in future uprate pensions in line with the consumer prices index (CPI) measure of inflation rather than the retail prices index (RPI) measure.

RPI inflation has been higher than CPI for most of the last two decades – partly because of the formula used to calculate it and partly because it covers a slightly different basket of goods and services.

Slower rate

So the 2010 decision to switch from CPI to RPI meant that pensions would tend to go up at a slower rate if inflation was the key determinant of the rate of increase.

Today we learnt that inflation on the RPI measure stood at 3.2 per cent in September. If this rate was still used, then weekly pension payments would go up by £3.52 a week instead of £2.97 – a difference of 55p a week or £28.60 a year.

That does not sound a lot but the point about the switch from RPI to CPI is that it will tend to produce lower increases year after year after year. So if the RPI measure had been used to uprate inflation over the last three years, the state pension would £1.09 a week higher from next April than under the CPI system – a difference of £56.68 a year.

One thing that might change this scenario is if average earnings start to go up by more than inflation. That was the norm before the recession of 2008. Since then, average earnings have consistently risen slower than inflation.

The Office for Budget Responsibility expects this to change sometime towards the end of 2014 or perhaps 2015 though there has been little sign of it happening so far.

The government could argue that this difference in pension payouts under the new and old systems is irrelevant because no one was planning to retain RPI as a benchmark for pension increases. Indeed, Labour was planning to switch to uprating pensions in line with earnings from 2012 – that would have produced even lower increases.

‘Insult’

It is worth remembering that Labour’s commitment to raising pensions in line with RPI when it was in power actually produced all sorts of political problems for it, because the index rose by less than earnings on such a regular basis.

In 2000, RPI was so low that it translated into a weekly pension increase of just 75p – a change which one Labour MP described at the time as the government’s “biggest mistake” and an “insult”.

When the coalition introduced the triple lock, there is no reason to believe it thought that this would produce lower pension increases. No doubt, ministers assumed that average earnings would be higher and would serve as the benchmark for pensions.

The problem for all parties is to find a rule for increasing pensions that is both affordable but also produces a rate that is acceptable to pensioners themselves.

And it can point to the 2.5 per cent guarantee included as the third component of the lock which meant that the “75p debacle” could never be repeated.

But an unintended consequence of this decision has been to lower the rate of growth of pensions. The problem for all parties is to find a rule for increasing pensions that is both affordable but also produces a rate that is acceptable to pensioners themselves.

Now even the triple lock itself is in doubt, with politicians on all sides suggesting that the question of how pension increases are determined will be re-opened after the next election.