The Office of National Statistics (ONS) has recommended that a new index be published, after it concluded that the formula used to produce the retail prices index (RPI) does not meet international standards.
A new RPI-based index will be published from March 2013 using a geometric formulation (Jevons), known as RPIJ.
A consultation on options for improving the RPI was prompted by the need to address the gap between the estimates produced by the RPI and the consumer prices index (CPI).
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The ONS research programme found that use of the arithmetic formulation (known as the Carli index formula) in the RPI is the primary source of the formula effect difference between the RPI and the CPI, and that this formulation does not meet current international standards.
In developing the recommendations, national statistician Jil Matheson also noted that there is significant value to users in maintaining the continuity of the existing RPI’s long-time series without major change, so that it may continue to be used for long-term indexation and for index-linked gilts and bonds in accordance with user expectations.
Therefore, while the arithmetic formulation would not be chosen were ONS constructing a new price index, the national statistician recommended that the formulae used at the elementary aggregate level in the RPI should remain unchanged. She recommended that the RPIJ sit alongside this.
Joanne Segars, chief executive at the NAPF, said: “Pension funds are relieved that RPI has been left intact because rewiring this crucial measure would have created upheaval for both inflation-linked pension fund investments, and the income of current and future pensioners.
“Reworking RPI would have given many pension funds some much-needed breathing space by reducing their liabilities, but it would also have cut the growth in pensions paid to former workers.
“A pensioner with an average RPI-linked final salary pension of £7,600 could have seen a £20,000 fall in their income over a 20-year retirement.
“The ONS is still doing work on overhauling CPI, so this was the wrong time to be reviewing RPI, and investors do not welcome the uncertainty and market disruption this announcement has created. Leaving RPI alone is the best option.”
It’s impossible to please everyone, but leaving RPI unchanged seems to meet the demands of the majority, particularly pensioners and investors. Some of the changes mooted could have saved the government as much as £2 billion per annum under payments from index-linked gilts which are linked to RPI.
Scheme sponsors already struggling with deficits may also be disappointed, as benefits fully linked to RPI might have reduced in cost by about a fifth if RPI had been fully realigned with CPI. Consultation respondents, who largely opted for maintaining the status quo, will clearly be satisfied with the outcome.
However, the anomaly still exists that pension scheme members’ benefits could be linked to either RPI or CPI, depending on which generation of rules the deeds of their scheme were written under so not all will be comforted by this decision.
A significant number of schemes have rules which provide for pension increases to be linked to RPI ‘or such other suitable index of prices’. A recent court case allowed the use of CPI in such circumstances. Now that the potential savings from realignment of RPI towards CPI have not come through, sponsors will be looking closely at such rules and may push for another index pointing to the ONS’s own comments on the limitations of RPI. Trustees will, of course, resist.
Many employers will be disappointed. Both they and the industry had expected an alteration to the calculation. One option could have shaved up to 1% off the RPI inflation rate, reducing deficits by possibly as much as 25%.
Instead, no change means inflation expectations are now likely to rise, pushing up liabilities and deficits. It will also boost the price of inflation-linked securities like gilts and swaps. That will make it more expensive to take inflation risk off the table via a buy-out.
As far as members are concerned, more price indices – like the proposed RPIJ – will give them more information and data, but it will also lead to more questions about the degree of their cost-of-living protection.
However, we are pleased that the ONS is reassuring everyone that we won’t get future methodology changes. We were concerned that this difficult issue might just drag on, leading to a long period of uncertainty.
This is not the outcome that most people were expecting. The national statistician had said that her consultation was primarily about ‘statistical methodology and best practice’ and the ONS had already concluded that a formula used to calculate price increases for 27% of the RPI basket has an ‘upward bias’.
Although there was too much uncertainty for the markets to have priced in the full change, some amendment to the main RPI had been anticipated by the markets and therefore ‘banked’ in the deficits that employers were expecting. Indeed, for some companies, this will have flowed through to their 2012 year-end accounts.
The future inflation rates implied by the gilt market increased significantly on the back of this news, perhaps adding about 4% to the liabilities of a typical final salary scheme with RPI-linked pension increases, although the impact may change as market conditions settle. The resulting increase in pension deficits will depend on investment strategy and will be less for those schemes with large holdings of index-linked gilts.
When the government switched some pension increases to CPI, the impact on employers and scheme members varied according to how scheme rules were written. Making RPI more like CPI would have extended the gains to many more private sector employers and the pain to more members. Instead, the differences will largely be preserved, though schemes rules may again play a part in determining how some employers and members are affected by today’s announcement.
The announcement is a big surprise. However, it seems that the consultation was overwhelmingly against change, and the desire to preserve a long-standing inflation measure predominated.
It is good news for investors and for pension scheme current and future pensioner members. However, it’s not good for pension scheme sponsors, who won’t get what was an expected material reduction in liabilities. Also, certain future prices linked to RPI (e.g. rail fares) will be higher as a result. It may also lead to higher increases to future state pensions, depending on what long-term increase formula for state pensions is revealed in the state pensions policy review announcement expected later in January.
We expect there to be an impact on markets, given that the majority of index-linked participants had over-sold index-linked bonds in advance expecting to purchase bonds after the announcement at lower prices. Therefore, there will be short-term recovery of these positions followed by the release of pent-up demand for index-linked bonds, which has been held back since the summer due to the uncertainty over this RPI formula review.
“It should be noted that the Bank of England and the Government are not bound by this recommendation from the ONS although it would be very difficult to proceed against it.”
The announcement from the ONS that construction of the RPI will remain unchanged and will not become closer aligned with the CPI is unexpected, but will be much welcomed by pensioners with incomes linked to RPI.
There was overwhelming support for the status quo from respondents to the consultation and plans for introduction of a new RPIJ index would appear to close the door on further harmonisation of the RPI and CPI in the short-term.
Arguably, markets had been expecting some degree of change and, if the construction of RPI had been completely aligned with CPI, there could have been further falls in longer-term expectations of RPI. This would have reduced the cost of providing RPI-linked pensions by as much as 10%. The announcement is likely to mean that longer-term expectations of RPI rise, effectively reversing out the earlier falls based on speculation about what the announcement would say. Early morning trade suggests this is the case.
Hard-pressed employers anticipating the windfall saving that would have occurred if RPI-linked pensions had fallen in value will not be happy as they will not enjoy the anticipated decrease in the cost of funding these benefits.
One good thing to come out of the announcement is that it ends uncertainty and enables scheme trustees and sponsors to get back to running their schemes based on actual, rather than speculative measures. Assumptions for CPI inflation are generally derived by making a deduction from objective measures for RPI inflation. Any decisions made recently regarding this difference should be reviewed to ensure they remain appropriate.
In light of the fact that we will be running with two key inflation indices we would call on the government to make an issuance of financial instruments linked to CPI. The absence of such bonds means there is no objective measure for future CPI inflation and any assumptions made are merely conjecture. This is not an ideal way to run pension schemes.
The ONS’ decision to keep the RPI methodology unchanged comes as a shock to investors. If the committee was purely focused on the statistical merits of the proposed changes, then there could have been no doubt that the RPI index methodology needs reform. This is apparent from the half-hearted apology from the ONS in its opening statement admitting to the substandard quality of the index.
The introduction of the new RPIJ index is designed to highlight the problem with the RPI index over time, and will probably eventually replace the RPI index as the key benchmark for compensating inflation-linked bond investors.
For now, HM Treasury has confirmed that it will not change the use of the RPI index for linkers.
The headline is ‘no change to RPI’, but in fact today’s decision is actually a positive decision to keep the significant changes accidentally introduced in 2010, although we expect the ONS to continue to investigate whether it can improve the index.
Back then, an apparently minor technical decision was made to improve the way clothing and footwear prices were collected. However, for various statistical reasons, those changes seem to have widened the gap between CPI and RPI by around an extra half a percent per year. That sounds small, but it could increase RPI-based benefits by about 10% over the course of 20 years.
Although this will be a relief to pensioners receiving RPI-linked benefits, the flip side is that employers’ costs are higher than they might reasonably have expected. The ONS has an ongoing task of ensuring its inflation calculations are robust, and we expect it will continue to investigate whether the difference between RPI and CPI can be defended.
ONS’s decision not to tinker with how RPI is formulated will be a sigh of relief for existing pensioners who have retained RPI as the method by which their pensions are increased and who were facing it morphing into CPI – the very thing they thought they had escaped after the 2010 changes.
Many in the pensions industry will also welcome the news. Trustees holding gilts will be pleased with this decision as the value of their assets won’t be diminished as a result of the expected change.
The development of the proposed new index, RPIJ, will be awaited with interest. This will mean that in future there will be four indices in use – CPI, CPIH (which includes housing costs), RPI and RPIJ. It is unclear at present what this additional index would be used for – although it would be available in future as an alternative to RPI. The ONS decision confirms what we had suspected all along, that there is no one right answer to inflation measurement.
The ONS consultation on inflation will not, against expectations, result in any major change to the calculation of RPI. Instead, yet another measure of inflation will be created. It will take time before we see what the new index will mean and where it will be used. This will no doubt lead to further confusion as to what inflation actually means, as it would appear we will now have at least three ways of measuring it.
The announcement means pension scheme funding levels will not receive the expected boost. As such, security for members of underfunded schemes will not improve and there will be no relief to the sponsors of these schemes (which will no doubt be especially galling for those who ‘missed out’ on the benefit of the previous switch to CPI, which occurred in 2010/11).
On the positive side, the announcement will mean that pensioners will retain the current value of their RPI-linked pension. A change could have meant their pensions would have been worth thousands of pounds less. Investors in RPI linked investment will also not suffer losses to future income.
This was a great opportunity for the Chancellor to align pensioners’ inflation proofing more closely with the actual reality of their expenditure and costs. RPI and CPI, which are used by the majority of pension schemes, are inadequate to offset the impact of inflation on pensioners. By contrast, the ‘triple lock’ used on the state pension, while very generous to pensioners, will be ruinously expensive for the tax payer in the long run. It makes far more sense for everyone involved to use one Pensioner Inflation Index for all these payments.