Pension schemes with CPI-linked liabilities could see a 10% hit to their funding levels

  • The government will consult in January on how to align RPI with CPIH, and when between 2025 and 2030 this change would take place
  • The new methodology would reduce RPI by around 1%. The value of RPI-linked assets could fall significantly as a result.
  • Many schemes use RPI-linked assets to hedge CPI-linked liabilities
  • Consequently, schemes with CPI-linked liabilities may see a significant reduction in their funding levels – possibly by 10% or more

The debate on the continued appropriateness of RPI as a measure of inflation resurfaced in January 2019, and a consultation is expected to take place in January 2020 on RPI being aligned with CPIH between 2025 and 2030. The new measure would be around 1% lower than the current RPI.

This means that pension liabilities linked to RPI will be lower than they otherwise would be. According to new analysis by Barnett Waddingham, schemes with RPI-linked liabilities are likely to see a significant reduction in their liability values – possibly by 10% or more. However, there is no similar impact where benefit increases are CPI-linked or fixed.  Many schemes with CPI-linked liabilities are using RPI-linked investments to hedge inflation risk.

Given the significant impact on the value of pension scheme liabilities and assets, the proposal will in turn affect scheme funding levels. The extent of the impact will depend on the proportion of liabilities that are linked to RPI inflation, as well as the level of hedging assets that they hold.

Over recent years many pension schemes have been advised to hedge inflation risks, and the worst hit schemes are likely to be those using RPI-linked assets to hedge CPI-linked liabilities. Assuming a 1% yearly fall in the future inflation measure, Barnett Waddingham’s analysis reveals that these schemes could see a fall in their funding levels as high as 12%. 

Having said this, schemes that have swum against the tide of guidance, with a high proportion of RPI-linked liabilities and a low level of RPI hedging, may see a significant improvement in their funding level. Those with inflation hedging strategies covering their RPI-linked risks but not their CPI-linked risks will be broadly insulated against the change. In terms of timings, if RPI was amended from 2025 rather than 2030, the impact on scheme funding would be slightly more pronounced.

"The Government runs the risk of punishing those who have been prudent, with a well-funded and well-risk-managed scheme, whereas those that have left risks unmanaged could be rewarded."
Ian Mills Principal, Barnett Waddingham

Ian Mills, Principal and Senior Investment Consultant at Barnett Waddingham, said: “This consultation may seem arcane and technical, but it could have seismic implications for all UK defined benefit pension schemes. The Government runs the risk of punishing those who have been prudent, with a well-funded and well-risk-managed scheme, whereas those that have 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.

“For scheme trustees, it’s largely a game of wait-and-see over the course of the consultation. Direct holders of inflation-linked assets may wish to input into the consultation next year to articulate how they will be affected by the proposals. All trustees should analyse their own inflation risks, quantifying their CPI/RPI ratio to understand how exposed they are to this change. Review inflation-related triggers, and for those with very high inflation hedge ratios it may be worth considering adjusting their inflation hedge ratio. Whilst this would increase the scheme’s exposure to general inflation risk, it would also reduce the exposure to the gap between RPI and CPI, and could result in a lower overall risk level.

“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. 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 just about making sure the pension schemes are compensated – it’s about making sure the pensioners are.”

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