Pensions, Purchasing-Power Risk, Inflation and Indexation

The rapid rise in inflation in 2006-07 has attracted attention – once again – both to how pensions systems should react to changes in prices, and to how they do so in practice. Although inflation is now falling as a result of lower commodity prices and weakening demand, this brings with it the risk ofdeflation – falling prices – which also raises questions as to how pension systems should react.Most OECD countries have a legislated commitment to indexation of pensions in payment. However, the empirical evidence in this paper shows that these rules have frequently been over-ridden. Furthermore,because indexation to price inflation rather than wage inflation is much more common – and wages can be expected to rise more rapidly than prices – the effect of following legislated indexation rules will be toreduce pensioner incomes compared with those of the working-age population. However, indexation to prices is less costly, allowing a larger initial pension than under earnings indexation for a given budgetconstraint.This paper sets out current, national indexation policies and historical data on how pensions have been adjusted in practice. It examines different indexation policies: to prices, earnings or a mix of the two thechoice of the price index and progressive indexation (where smaller pensions are increased more rapidly than larger).