16th July 2012
Potential changes to RPI
Consultation to converge RPI and CPI
The Office for National Statistics (ONS) has recently launched a consultation proposing changes to measures of UK inflation - the Consumer Prices Index (CPI) and the Retail Prices Index (RPI). Both of these inflation measures are widely used for increasing benefits in UK pension schemes.
The main proposal is to replace the CPI with a new version that includes housing costs. This would be called CPIH and is likely to be closer to the RPI than the current CPI (as RPI already includes a measure of housing costs). The introduction of CPIH will only affect UK pension schemes if the government decides to use it as the measure of inflation for increasing pension benefits.
While the housing proposals are important, the ONS also states in the consultation that it aims to remove any “unjustifiable and unnecessary gap” resulting from the different mathematical formulae used for calculating RPI and CPI.
Reducing this gap would directly affect pensions linked to inflation, as well as returns of inflation-linked gilts.
Differences between RPI and CPI
RPI and CPI both measure the general level of prices. However, they are different, with RPI expected to be higher than CPI. The difference could be as much as 1.5% a year on average. Reasons for the difference include:
- The CPI excludes some goods and services included in the RPI. For example, vehicle licence and TV licence duty are excluded but more importantly some housing costs, including mortgage interest payments, household insurance and council tax (but not utility bills and rents), are excluded from the CPI.
- The CPI includes some costs that are not in the RPI, such as charges for financial services and university accommodation fees.
- The mathematical formulae used to calculate the indices differ. For a given set of data, the geometric mean method, which is used for the calculation of CPI, will produce a smaller value than the arithmetic mean, which is used for the calculation of RPI.
If the ONS decides the difference between the RPI and the CPI is unjustifiable, it may seek to reduce or eliminate it. If it does so, the most likely outcome would be to reduce the RPI measure of inflation so that it is closer to the CPI. The reduction in the RPI could be as much as 0.5% a year.
Impact of reducing the RPI
Reducing the RPI measure of inflation would make RPI-linked pension payments lower than they would have otherwise been, thus reducing the value placed on these pension liabilities. This would provide some relief for employers of UK occupational schemes but at the expense of pension scheme members.
In addition, reducing the RPI may be detrimental to investors of index-linked gilts as future coupon and redemption payments could be of a lower value than they currently are. Consequently, pension schemes that invest in this asset class could see their assets fall in value.
These proposals are at an early stage but some alignment between RPI and CPI looks a distinct possibility.
If you would like to know more about the potential changes to the RPI and the CPI, and how this could impact your scheme(s), please get in touch.