The Retail Price Index (RPI) plays a significant role on both the asset and liability side of a pension scheme and any changes to the Index will have a far-reaching impact. Therefore, trustees need to take note of the recently proposed reforms to RPI.
What are the reforms?
In September last year, Sajid Javid, then Chancellor of the Exchequer, confirmed a public consultation would be held on the implementation of the UK Statistics Authority’s proposed reforms to RPI, with a specific focus on aligning it to the Consumer Price Index including Housing costs (“CPIH”).
These changes are proposed to take effect from 2030, however, to be considered as part of the public consultation, this date could be brought forward to 2025.
What impact will this have on pension schemes?
The impact of the reforms relates to the fact that the method of calculation is different for RPI and CPIH, which results in CPIH being lower by approximately 1% on average (this is sometimes referred to as the “formula effect” or “wedge”). This means that any instrument that has payments with a linkage to RPI, index-linked gilts for example, will see a reduction in those payments, thereby reducing the value of the instrument.
An individual’s pension or annuity, where payment increases are linked to RPI, would also see a reduction in the future expected cash flows.
Pension schemes will see the following effects:
- If a scheme has RPI linked benefits, the total liability of the scheme can be expected to reduce.
- Where schemes have hedged CPI linked liabilities using RPI linked assets, a loss can be expected (it is not uncommon for CPI linked liabilities to be hedged using RPI linked assets due to the fact that CPI linked assets are much less common).
The net position will be different for each individual scheme - action can be taken now to reduce the risk/impact of the proposed reforms, though the markets already seem to be pricing in some of the expected effects.
There are many aspects of the reforms which are still undecided, and, as a result, leave the potential impact uncertain:
- Possible compensation to those holding index-linked gilts (Insight Investment has estimated the potential loss to gilt investors at around £90 billion).
- The date at which the reforms will be implemented.
- What other related indices will be affected.
Once the exact nature of the reforms is finalised, the impact will be easier to assess. However, given the length of time until implementation, there is scope for further changes. Trustees and other affected parties should keep updated on developments and maintain a dialogue with their investment consultant to ensure the correct measures are put in place.
Meanwhile, schemes should at least be aware of any mismatch on assets intended to hedge inflation risk and trustees should satisfy themselves that they remain comfortable with the overall risk profile of their investment strategy.