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The Actuary The magazine of the Institute & Faculty of Actuaries

Keeping RPI inflation measure unchanged ‘will safeguard pensions’

The National Statistician has decided against a change in the way inflation is calculated that could have reduced some pensioner incomes by thousands of pounds.

Old age pensions saving
A change in RPI could have reduced pensioners' retirement income

Jill Matheson announced today that, following a consultation on how the Retail Prices Index could be improved, she had concluded that the formula used to work out the measure should remain unchanged.

It had been widely anticipated that RPI would be brought more in line with the slower-rising Consumer Prices Index. But today’s decision means it will continue to be used for the uprating of private sector pensions and index-linked bonds, while a new inflation measure, known as RPIJ, will also be developed by March 2013.

In a statement, the Office for National Statistics said Matheson had ‘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’.

It added: ‘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.’

Tom McPhail, head of pensions research at consultants Hargreaves Lansdown, said the decision would be welcomed by pensioners with benefits linked to the RPI index who could have seen their income drop by between 0.5% and 1% a year.

But he added: ‘It will probably come as a disappointment to employers sponsoring final salary schemes. A reduction in the rate of RPI would have reduced some pension scheme liabilities; this in turn would have reduced the amount of money which employers have to pump into these schemes to reduce their deficits.’

Alan Collins, head of corporate advisory services for consultancy Spence and Partners, said any change could have meant RPI-linked pensions could have been worth thousands of pounds less. Avoiding a change would also mean investors in RPI-linked investment avoid losses to their future income.

He warned, however, that creating another measure of inflation would ‘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’.

Zoe Lynch, partner at pensions law firm Sackers, added: ‘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.’

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UK index-linked gilts market uses RPI as the benchmark. If the RPI is lowered, the future nominal returns for these bond investors would be lowered.
In addition, other investments where returns are linked to RPI would've been adversely affected. Though, it would've been a good news for UK defined benefit pension schemes currently under-hedged against inflation, as indeed many are. As member benefits are likely index linked, any reduction in RPI would've lowered the future liabilities of these pension funds and improved their funding position. If scheme members were
to receive lower future increases in their income,
the effective investment hurdle rate for these
pension funds would've reduced.

Kajal Sawhney (25/01/2013 06:42:59)

The arithmetic method used for the RPI assumes that when prices change, consumers keep the quantities they buy unchanged; this is not reasonable if the higher prices are because the item is in short supply, as potatoes were one year some time ago. The geometric method used fror the CPI seems to assume that consumers keep the amounts they spend unchanged, so reduce the qunatities of those things that have gone up a lot. Economists would describe the first as assuming price elasticity zero, the second as assuming price elasticity of unity. In practice neither is right, because price elasticities must vary a lot between different goods (essentials and luxuries) and between different consumers (poor and affluent). For poorer pensioners, the RPI looks a lot more realistic; but for the general public something in between might be best. But I am glad that the formula is to remain; it could have destroyed confidence in index-linked stocks if the government seemd to be fiddling the payments.

David Wilkie (10/01/2013 17:27:47)