As the government’s consultation to make changes to the retail price index draws to a close, the impact of aligning the inflation measure with the consumer price index including housing costs has increased by £10bn due to the pandemic.
In a joint consultation published in March by the UK Statistics Authority and the Treasury, the government proposed to bring the data sources from the CPIH into the RPI, effectively aligning the two indices.
Following the transition, monthly growth rates for the RPI and the CPIH will be the same, whereas annual growth rates will converge after the first year. Based on recent experience, this change would mean the RPI will be lower, on average, by 1 percentage point a year.
The RPI has typically run around 1 percentage point higher than the CPI and its variants over the years. While restating RPI liabilities as CPI could be beneficial for defined benefit schemes, the corresponding drop in the value of RPI hedging assets means that some schemes could be exposed to funding level drops.
The Treasury has said it would have an outcome in autumn, and at that time you will have pension schemes with massive holes. It is going to hurt people’s pockets as soon as the announcement is made, because financial markets will anticipate that going forward and reflect it today
Jos Vermeulen, Insight Investment
According to analysis from Insight Investment, simply aligning the two inflation measures will translate into a transfer of wealth between £100bn and £130bn to the government, depending on the year it is introduced.
However, this is an updated figure from the previous estimate of £90bn to £120bn, as low interest rates stemming from the coronavirus crisis have worsened the material impact of the RPI changes for index-linked gilts holders.
Jos Vermeulen, head of solution design at Insight Investment, told Pensions Expert: “If you think about how you would calculate the impact [of aligning RPI with CPIH] in today’s terms, you would discount those future 1 per cent at lower interest rates as these have been falling because of Covid-19.”
The long-awaited consultation on the RPI did not bring a definite answer to when this change would be implemented, and asks whether the change should be introduced at a date other than 2030 and, if so, when between 2025 and 2030.
Mr Vermeulen is not so concerned about the date of implementation, as the impact of the change will be immediate.
“The Treasury has said it would have an outcome in autumn, and at that time you will have pension schemes with massive holes. It is going to hurt people’s pockets as soon as the announcement is made, because financial markets will anticipate that going forward and reflect it today.”
“How are companies, which are facing Covid-19 and other difficulties, going to plug this hole in their pension schemes?” he asked.
Industry body demands compensation
In its response to the government’s consultation, the Pensions and Lifetime Savings Association pointed out that DB schemes “will be significantly impacted if the government decides to go ahead with the change”.
Currently, these pension funds invest an estimated £470bn in index-linked bonds, with 29 per cent of private sector scheme assets invested in index-linked bonds. A simple switch to the CPIH is expected to reduce the value of these pension scheme investments by £80bn if done in 2025, and £60bn if made in 2030, the PLSA stated.
Tiffany Tsang, senior policy lead for the Local Government Pension Scheme and DB at the PLSA, noted that “the decision to develop a more robust measure for inflation is the right one, but the proposed methodology risks billions of pounds in pension assets”.
“Pension schemes have made RPI-linked investments in good faith, and under the guidance of the regulators, to prudently fund pension benefits. They should not face shortfalls as a result of the changes,” she added.
In order for the transition between the inflation indices to be made in a fair and equitable way, the PLSA suggest that the government deliberately adjusts index-linked gilts from the RPI to the CPIH plus an adjustment, which would reflect “the expected long-term average future income of RPI over the new inflation measure”.
Insight Investment is also making a similar proposal. “This change doesn’t need to unnecessarily create winners and losers, they can fix the statistics by setting RPI equal to CPIH plus 1 per cent,” Mr Vermeulen said.
He noted that when investors “bought index-linked gilts from the government, they did so on the basis that it would be linked to the RPI and that it would remain unchanged”.
In its response to the consultation, Insight Investment stated that “implementing the change as proposed would lead to a significant loss of confidence in the UK government among investors”.
“If markets perceive that any change effectively reneges on contractual obligations, or leads to a redistribution of wealth away from investors to the government, this could have implications for the government’s perceived creditworthiness, and could be subject to legal challenge,” the document read.
The Society of Pension Professionals, which also made a submission to the consultation, stated that in assessing whether there should be compensation, the Treasury should also consider the position of individuals who used their own assets to buy a RPI-linked annuity.
“The annuity payments will be lower in future than anticipated, but the amount paid will not change nor, under the proposals, will the member receive a refund or compensation,” it said.
BA pension trustee urges against RPI changes
The chair of Airways Pension Scheme Trustee Ltd, Roger Maynard, has warned that possible reforms of the retail price index could cause great injustices, as well as undermining trust in the issuance of index-linked gilts.
Calls for government to create working group
The PLSA is also calling for the government to address the implications of changing the RPI “in a way that allows various stakeholders to provide input to determine the most equitable way” for the transition to occur.
The industry body noted that a precedent has already been set in the case of Libor, where a “working group was established to ascertain that the transition to the replacement index, Sonia, minimised the impact on stakeholders”.
As a result, the PLSA is urging the government to only make changes to the RPI by 2030, as it will be a more viable solution allowing for the establishment of a working group for the transition, while giving investors in index-linked gilts enough time to prepare and provide a better outcome for pension scheme members.
