Summary
The Consumer Prices Advisory Committee (CPAC) has recommended a change in the method of calculation of the RPI, to eliminate “unjustified causes” in the difference between Retail Price inflation and Consumer Price inflation (CPI). Any such change is likely to result in a reduction in scheme liabilities that are linked to the RPI, although there will be a corresponding fall in the value of index-linked Gilts, whose returns are also linked to the RPI.
Background
CPI has tended to be lower than RPI in general, partly because it is calculated differently (using geometric averaging rather than arithmetic averaging) and partly because it excludes the costs of owner-occupied housing. In the past the difference between the two has averaged approximately 0.7% per annum. The Office for Budget Responsibility (OBR) recently issued a report about the long-run difference between RPI and CPI. Their conclusion was that the difference is expected to grow to between 1.3% pa and 1.5% pa in future, made up 0.5% pa for housing costs and 0.8% to 1% pa from the method of calculation.
The changes that CPAC is considering relate to the collection of prices for clothing, since these account for the majority of the difference arising from the formula effect. However, they are considering also the inclusion of housing costs and council tax into the Consumer Price Index (CPI), which will reduce further the difference between the two indices, and so also between the inflation rates that they imply.
Index-linked Gilts
Returns on Index-linked Gilts (ILGs) issued prior to 2005 are based on Retail Price inflation with an 8-month time lag, whereas more recent ILGs use only a 3-month lag. If the calculation of RPI is changed, the holders of the older ILGs (with the 8-month lag) have the right to sell those ILGs back to the Government. Holders of the post-2005 ILGs have no such rights. However, the price at which the Government would buy back the pre-2005 Gilts is less than market value, reflecting only accrued inflation rather than the effect of falls in yields. Thus, holders of all ILGs may expect a reduction in the value of their investments.
Impact
The impact on schemes will vary, depending on the extent to which RPI is used to increase benefits and the extent to which scheme assets are linked to RPI, either through index-linked Gilts or through inflation swaps. If you would like advice specific to your scheme please contact us at info@censeo.uk.com.