By Professor Donald Hirsch, Policy Adviser to the Trust
A now familiar sound of late summer is the debate over the amount by which benefits and pensions should be uprated next spring. These upratings matter: even small adjustments in the annual percentages by which entitlements rise will, over time, have huge effects on future benefit and pension rates.
It’s therefore significant that, once again, ministers are briefing to float ideas for departing from usual uprating rules in order to limit the increases and save money. One is to base inflation-linked benefits increases on a different month than usual. Another is to ignore bonuses this year when linking pensions to earnings. Both of these ideas are highly spurious, as I explain below.
But why are these issues even being raised? Until a decade ago, inflation-uprating on a long-established formula was a formality. Even the Thatcher government, with all its cuts, consistently pegged benefit rates to inflation. A decade ago George Osborne broke with that practice, and in 2015-19 working age benefits were frozen completely. We have now returned to inflation-uprating as an expectation, but one more quickly challenged or undermined where resources are tight.
This goes against the promise first articulated by David Cameron on entering Downing Street, and often repeated by the four prime ministers since then, that the government will protect the poorest and most vulnerable. Yes, there are hard fiscal choices to be made, but making the poor poorer should not be one of them. We need to turn to an unquestioned acceptance that benefit rates will not fall in real terms as a result of inflation. (And in doing so, ideally, seeking to select an inflation measure that better reflects actual changes in costs for low income households than CPI does at present: it underestimates inflation for these groups because the cost of basics is rising faster than average consumer prices.)
An infuriating counter-argument at present is that with falling inflation rates, an April 2024 uprating based on the previous September’s rate will over-index compared to the inflation rate when it is implemented. So for example if inflation is 6% in September but only 3% in April, a 6% uprating would raise benefits by 3% in real terms. But two years ago, when inflation was instead accelerating there was no hesitation in doing the reverse, with 3% increases based on the previous September coming in at a time inflation had reached 9%. Any objection was met with the mantra that for administrative reasons increases needed preparing long in advance. So what’s changed? Well it’s true that Universal Credit, which is more thoroughly computerised, has got closer to replacing the legacy benefits system, so changes can be implemented faster. But if there’s a proposal therefore to base increases on January inflation from now on, it would be essential to take account of all price increases between September 2022 and January 2024 – ie a sixteen-month period. Not to do so would be to miss out permanently a period of four months at the end of last year when prices were rising rapidly. (But such a 16-month uprating would obviously be higher than one based only on the 12 months to September, ie retaining the current formula, so the Treasury is unlikely to want to replace it with a January uprating if this meant taking all 16 months into account.)
The specific proposal for changing the way the triple lock pension rule is applied this year also involves some sleight of hand. The issue here is that earnings indexation, which will apply this year, will be artificially boosted by some one-off public sector bonuses, so maybe a figure not including bonuses should be used on this occasion. The trouble is that a reversion next year to a percentage increase based on earnings including bonuses would also be artificially depressed by the loss of bonuses in that year.
If you’re finding this hard to get your head around, here’s an illustrative example. A public sector worker paid £20,000 a year basic gets, say, a 5% pay rise this year, to £21,000 plus a £1000 bonus. This is a £2,000 or 10% increase in pay including bonuses. But the government chooses on this occasion to apply only the 5% rise to the earnings-based increase in pensions. Next year, they get no bonus, and lets say regular pay increases by 5% again, from £21,000 to £22,050. The government reverts to its default policy of looking at change in earnings including bonuses, which have risen only from £22,000 to £22,050, a negligible amount – just 0.2%. So over the two years, actual earnings have risen by just over 10%, but only 5% of this has been taken into account in the increase of pensions – the amount by which post-bonus earnings rose in the first year
So it’s better to stick with one system, accepting that it will have some quirks artificially creating higher or lower increases, but counting on these averaging out over time. The one legitimate counter-example occurred in the 2022 pension uprating, when a very sharp annual rise in earnings was largely a recovery from the temporary fall in the pandemic. Since the triple lock had caused pensions to rise even during that earlier period when earnings fell, the result would have been for pensions to rise far faster than earnings over the two years period – so an inflation-only uprating was applied instead.
But the main reason this decision felt legitimate was because it was a rather extreme consequence of a rather illogical formula. Particularly during unstable periods when earnings sometimes rise faster and sometimes slower than prices, increasing pensions by the higher of the two (or by 2.5% if that’s more) creates much greater increases in pensions than was intended by the designers of this policy, at a time when earnings normally rose significantly more than prices. The idea was that they keep up with earnings in most years, without falling in real terms during short recessions when earnings briefly fell relative to prices. The consequence has in fact been for pensions to rise by much more than either earnings or prices over a period of a few years. This over-indexation for pensioners is not as over-generous as it sounds: you could see it as making up with the huge fall in pensions relative to earnings during previous years when earnings were growing fast in real terms but pensions were pegged only to prices. But looking ahead, pensions can’t keep rising relative to earnings forever.
A much better formula would start with price uprating, boosted where needed to reflect long-term changes in earnings so that pensions did not end up falling as a proportion of earnings over periods where real earnings were rising. Better to find a formula we can all believe in than to feel the need to fiddle with it where it produces too generous results. We need to design systems that give fair protection to people’s incomes, and then learn to stick with them.