The liabilities of most UK defined benefit pension schemes are linked to inflation. Recent proposals to change the most widely used measure of inflation, the Retail Price Index (RPI), could have a significant impact on many pensioners. If the changes are implemented, the retirement income for many may be cut, and pension schemes may also find their funding level reduced. Given these potential consequences, we believe now is a good time to assess the proposals and consider how to respond.
UK pension schemes typically offer inflation-linked pensions, and most are linked to RPI. A minority link their pensions to an alternative inflation measure, the Consumer Price Index (CPI).
Flaws in the calculation methodology of RPI have long been recognised. One example is the ‘formula effect’, whereby using the ‘Carli’ mathematical formula is estimated to increase the annual growth of RPI by around 0.7 percentage points, relative to comparable inflation measures.
This effect was exacerbated in 2010, when the range of clothing prices collected to calculate inflation was widened. This led to an expected increase in the margin between RPI and CPI, driven by a divergence in the contribution from clothing prices (see graphic). In total this led to an expected addition of c.0.3 percentage points per year1.
The government now favours CPI, which excludes these flaws and is perceived to reflect inflation more accurately.
RPI back in the spotlight
In July 2018, the House of Lords Economic Affairs Committee launched a public consultation on how inflation should be measured, and published the resulting review in January 2019.2
The review said the UK Statistics Authority has a statutory duty to fix the flaws within RPI. It also recommended that the government use only one measure of UK inflation – an improved version of RPI would be a potential candidate.
Implications for pension schemes
These changes could reduce many pensioners’ future income. Removing the impact of the 2010 changes to clothing calculations would likely lower RPI by 0.3 percentage points each year, or six percentage points over 20 years. This effect would be much larger if RPI was brought fully into line with CPI.
Another likely impact would be a fall in the price of RPI-linked assets, of which the majority is index-linked gilts. All else being equal, this would lead to a fall in the funding level of a scheme using RPI-linked assets to hedge CPI-linked liabilities; this mismatch between hedging assets and CPI-linked liabilities is relatively common due to the lack of CPI-linked assets. The value of RPI-linked assets would decline without a corresponding fall in the value of liabilities, and for the average scheme in this bracket, we estimate a potential negative impact of as much as 10% on its funding level.
Time to take action
Given these implications, we believe both trustees and sponsors would benefit from understanding the full proposals and their impact. Stakeholders may wish to ask their advisers to quantify the effects, and to raise awareness amongst policymakers.
If the negative effects of the proposed changes are fully understood, we would expect the government to consider how to mitigate them if they were implemented. This will likely prove challenging. Also, it may be a good time to discuss with the scheme’s investment manager how the inflation hedge might evolve. For example, it may become appropriate to switch from RPI-linked to CPI-linked hedging assets to achieve a more accurate inflation hedge, if the CPI-linked market develops.
It may be years yet before the government presents a clear answer on how it will resolve the questions around the use of RPI. But taking action now could prevent surprises in the future.
1 https://www.ons.gov.uk/economy/inflationandpriceindices/articles/ shortcomingsoftheretailpricesindexasameasureofinflation/2018-03-08
2 https://www.parliament.uk/business/committees/committees-a-z/lords-select/ economic-affairs-committee/inquiries/parliament-2017/the-use-of-rpi/
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