11 September 2019
Last week, in a coordinated announcement, the UK Statistics Authority and the Chancellor effectively confirmed that:
- The ONS’s intention is that, from no later than 2030, the formulae underlying RPI inflation will be changed to become the formulae underlying CPIH inflation (there is no indication that this is to be consulted on, and this is not a Government decision)
- The Chancellor will consult in January about whether to bring forward this change to 2025 (only he has the power to do this, because of quirks in index-linked gilt contracts)
This follows a Lords’ Committee report on inflation earlier in the year, that highlighted what has been known for some time: the RPI formulae has a number of known errors in it, and the ONS believes CPIH is a better measure of inflation. I wrote about this in my blog last summer. For some time, the ONS have been urging people not to use RPI as a statistic, but they now feel the need to take action to ensure it is phased out. And they have indeed taken bold action, albeit only effective from 2030!
The impact on pensions and pension schemes can be expected to be significant. In particular, the CPIH formulae can be expected to result in an inflation measure that is around 1% per annum less than the RPI formulae. Amongst other things, this means:
- Where pension increases are linked to RPI, pensioners can expect to get lower pension increases beyond 2030 than they otherwise would have had
- Where pension schemes have predominantly RPI-linked pension increases, but have only partially hedged inflation (and many schemes are in this situation), schemes should make a net financial gain from the change
- However, where pension schemes have predominantly CPI pension increases, but have hedged those increases with RPI instruments (like index-linked gilts), schemes are likely to suffer a net financial loss from the change
The gains and losses can be expected to impact actuarial funding numbers, company accounting numbers (IAS19) and self-sufficiency numbers, which are increasingly being used in long-term journey plans that span into the 2030’s. Further, we expect there will be a significant positive impact on the cost of removing pension risk, with buy-in and buyout insurers, and consolidators all likely to offer to accept RPI related pension liabilities for lower amounts. Of course, many schemes have a range of different pension increases paid to different members, with only partial hedging in their investments, and the net impact is therefore likely to vary considerably from one scheme to another and will only be felt as markets adjust and at upcoming valuation and accounting dates.
Interestingly, the initial response of index-linked gilt markets has been muted. It is almost as if the market doesn’t yet believe that the announced changes will happen. Why is this? Well there are a number of potential reasons including:
- The market has already priced in some of the change over recent years as the ONS and others signalled their dislike of RPI
- The market believes that “compensation” will be paid to gilt holders, discussed further below
- The market is taking some time to process the statement and work out whether or not it can rely on it
- The market is primarily driven by supply / demand from UK pension schemes, and there has not been a change in this (yet)
- There is a lot of other factors impacting the market at the moment, including Brexit and recession risk
If the muted impact of markets continues for a while, it may mean that some of the financial impacts on pension schemes outlined above may not be seen for some time. In such an environment, there may be short-term market opportunities.
As noted above, one possible reason for the muted response is the possibility of “compensation” for index-linked gilt holders. This has been raised by a number of market commentators and investment managers. There is clearly some way to go on this, but there is no indication from the documents published so far that this is in the mind of the ONS or Chancellor, so I suspect that that would need to be fought in the courts.
This is an important announcement with a big financial impact on pensioners, pension schemes, and their corporate sponsors. Everyone involved in pensions should keep a close eye on developments, tracking the impact on markets and watching out for the January consultation.
Jonathan Camfield is a Partner at LCP and a member of the Advisory Panel for Consumer Prices, that advises the National Statistician on inflation matters.