Do you understand inflation’s impact on your people’s retirement? 

Soaring inflation has changed the landscape for defined contribution (DC) pension schemes by reducing the purchasing power of pensions for both retirees and future retirees — with more of an impact than the headline inflation numbers suggest.

This creates a challenge for those overseeing pension schemes, whose aim is to provide a pension which allows people to be able to afford to retire. And for employers this scenario creates HR, succession and business risks.

If you haven’t reviewed your scheme for retirement adequacy in the past few years — and our research shows many haven’t — now is the time to act. And even if you have, you should do it again to take account of the new world we face.

The Pension and Lifetime Savings Association’s (PLSA) Retirement Living Standards are a valuable guide to how much individual pension savers will need for a certain standard of living when they stop work. Based on academic research, they show the amount of money needed to retire based on a “minimum”, “moderate” or “comfortable” lifestyle, and what people are buying and consuming in retirement.

The PLSA updated these measures in January 2023 to include the effects of inflation — and the results were sobering. Over the course of a year, inflation had increased the cost of all three living standards significantly. 

The cost of a moderate retirement rose 12% to £23,300 for a single person and 11% to £34,000 for a couple. For a comfortable retirement the cost of living rose 11% to £37,300 for an individual and 10% to £54,500 for a couple. These figures are for outside London; the amounts needed to sustain the same standard of living in London are higher (although the percentage increases from last year are roughly the same). 

Those on lower incomes were worst hit as the cost of a minimum retirement lifestyle jumped 18% to £12,800 for a single person and 19% to £19,900 for a couple (again, outside London). This was because people on lower incomes spend a bigger proportion of their budgets on food, social costs and energy, which have been the biggest contributors to pensioner inflation.

This would be fine if both investment returns and contribution levels (that is, salaries) had increased by similar amounts, but we know that hasn’t been the case. 2022 was a challenging year for DC investment and salaries are not keeping pace with pensioner inflation.

The PLSA adjusted its standards based on changes in prices in the year to April 2022. Consumer Price Inflation dipped less than expected to 8.7% in the year to April 2023 and core inflation rose. Food prices rose at an annual rate of 19.1%. These figures indicate that the PLSA standards will face further significant erosion over the next year — and potentially longer if high inflation continues from here.

All of this means that the ability of schemes to provide a good outcome has been reduced — so investments and communications to engage employees need to work harder to compensate.

Data gathered by Mercer’s DC MOT pension audit shows how far behind many schemes were in even before inflation surged. Key findings include:

About two-thirds of schemes haven’t reviewed their contribution design in the past three years. Checking that contributions are appropriate gives members a better chance of achieving the retirement they expect. 

• More than one-quarter of employers pay in more than the employee and almost all exceed the minimum 3% contribution. A substantial number pay in 10% or more. All the more reason, then, to check that your contributions are effective.

• The PLSA standards are an industry benchmark for retirement adequacy but about three-quarters of schemes aren’t modelling their members’ outcomes to shape their investment strategy and/or contribution structure.

• More than seven years after the pensions freedoms legislation, some DC schemes are still targeting annuity purchase with members invested in gilts as they approach retirement. These schemes will have been severely affected by the rise in gilt yields in response to high inflation. This is fine as long as members intend to buy an annuity. But to say that annuities have become cheaper in response to heavy losses in gilts and bonds is cold comfort for someone not planning to purchase an annuity.

If you haven’t reviewed these key considerations, now is the time to do so. And even if you have, you may need to look again. The world has changed dramatically and what seemed appropriate 18 months ago is unlikely to be suitable now.

It is important to engage with employees to help them make the right level of contributions to fund their retirement — particularly if the cost of living crisis is causing people to consider reducing the amount they pay into their pensions. But communication may not be enough. The Bank of England has said high inflation has made us all poorer and this applies to DC pensions as well as day-to-day living. 

Salaries lagging inflation has caused a “realised loss” in the ability of DC savers to target a certain standard of living, as companies are unlikely to give pay rises significantly in excess of inflation in the future to account for below-inflation pay rises now.

We calculate that, all else being equal, a 25-year-old entering a DC pension scheme today will need around an extra 0.5% of investment return every year until retirement due to high pensioner inflation. This is a significant requirement that is likely to intensify over the next couple of years. This scenario has implications for investment strategies, which may need to consider whether levels of investment risk are correct. 

As a Friend of the Retirement Living Standards, Mercer helps fund research that keeps the standards up to date and relevant. We sit on the PLSA’s working group and include the standards in our retirement adequacy and investment strategy design as a matter of course. We do this to help ensure schemes are targeting, measuring and governing continually against the scheme’s ability to provide a good member outcome. 

We are here to help you navigate this changed environment. Our Retirement Readiness Index measures your scheme against the PLSA standards to provide insights into scheme design, investments and more, with the focus squarely on improving outcomes. 

More broadly, Mercer’s DC MOT is a quick, comprehensive pension plan review that benchmarks your scheme’s retirement adequacy and 11 other key measures against other UK employers and Mercer’s view of best practice for DC pension schemes.

Get in touch with your usual Mercer consultant to find out how we can help.