Will RPI recalculation punish the prudent and reward the reckless?

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The Government is consulting on changing the calculation of RPI.  This could mean that those who’ve been prudent and got their scheme well-funded and well-risk-managed could end up punished, whereas those that have been reckless and left risks unmanaged could be rewarded. The Government needs to be careful about moral pitfalls like this, as setting such a precedent can dangerously affect trust and behaviour. 

On 4 September, there was a stage-managed publication of letters between two gentlemen who are both well-known to the pensions industry.  The news was dominated by other events, but this will have a profound impact on almost every defined benefit (DB) pension scheme.  Sajid Javid MP, the Chancellor of the Exchequer, and Sir David Norgrove, the Chair of the UK Statistics Authority and former Chair of the Pensions Regulator, wrote to each other about the dry and somewhat technical issues around the calculation of the Retail Price Index (RPI).  

The upshot of this is that there is a proposal to amend the calculation methodology of the RPI to bring it in line with the Consumer Prices Index (CPI).  RPI will then be, in effect, identical to the CPIH (i.e. the CPI including housing costs). By law, the Chancellor’s consent is required for such a change before 2030, but he has proposed that this could happen from 2025. A consultation process is expected in January.

Changing the RPI in this way is likely to mean smaller annual pension increases for millions of pensioners in the future. It’s also likely to mean even lower prospective returns for holders of index-linked gilts, or inflation-linked LDI strategies. Putting a figure on this is hard, but it could easily mean that inflation, as measured by the RPI, will be around 1% lower than it otherwise would be.  

Consequences for DB pensions?

On the day of the announcement, prices of long-term index-linked gilts fell sharply, as the market anticipated significantly lower future RPI inflation. However, prices have since recovered. It’s unclear whether this is because the market does not believe the change will occur or whether inflationary fears have picked-up for other reasons, offsetting the initial move. It may also reflect a belief of market participants that such a change could not be countenanced without offering bond holders compensation to offset the effect.

The conversations we have had with some of the leading bond and LDI managers suggest that there is indeed a widespread belief that there will be some form of compensation offered to bond holders. However, in our view, it’s not certain there will be and, even if there is, it’s not clear how this compensation would work. We can envisage various different ways compensation could be structured, impacting the various interested parties quite differently. It’s quite possible – maybe even likely – that bond holders will be protected whereas individual pensioners will not.

However this pans out, it will have significant consequences for almost every UK DB pension scheme.  Many pension schemes’ rules require them to use the RPI for pension increases and any pension scheme that has hedged inflation risk has almost certainly done so by reference to the RPI, rather than CPI or CPIH.  The effects could be very significant, depending on the specific circumstances and how any compensation is structured. Schemes could see their funding positions move by a lot – maybe even up to 20% in extreme cases, and potentially in either direction.  

Will the PPF increase levies?

One group of pension scheme members who might be particularly hard hit are those that are well-funded and have significantly de-risked their schemes. For example, schemes with CPI-linked pension increases, that have hedged all their inflation exposure, may well find their liabilities don’t change but that the value of their inflation hedges fall, potentially pushing them into a material deficit once more.  

The PPF is one such scheme. It has CPI-linked pension increases (as set by the regulations) and has a significant RPI-linked inflation hedging programme. Its own numbers show that a 0.5% shift in the gap between RPI and CPI could cost it £2bn – so a 1% shift is really going to hurt. To put this into context, the PPF’s annual levy income for 2018/19 was estimated at around £550m, so we’re looking at an impact equivalent to several years’ worth of levies. The PPF may need to increase levies to rebuild its surplus.

On the flip side, schemes that have RPI-linked pension increases but have not hedged inflation risks at all may find that their liabilities fall with no commensurate move in asset values. Their funding positions could rise significantly.

Financial security at risk?

We also mustn’t lose sight of the fact that we’re talking about the financial security of millions of people here. Changing the calculation methodology as proposed may sound like an arcane area of actuarial technobabble, but it has the potential to bring hundreds of thousands – perhaps millions – of pensioners slowly back into poverty. Whilst the financial institutions affected will lobby powerfully to argue their case for compensation, I hope that we, the pensions industry, can come together to fight the corner of the people who matter most. This isn’t about making sure the pension schemes are compensated – it’s about making sure the pensioners are.

There are lots of complex and interlocking issues here, so it won’t be easy for pension trustees to identify all the issues without help. We'll be sharing more information over the coming months, setting out all the considerations to help you. In the meantime, please do get in touch if you’d like to discuss how we can help you tackle this pressing issue.