RPI Reform: should you be taking action?

United KingdomScotland

On Budget Day, currently 11 March 2020, the Government is expected to start a consultation on changing how the Retail Prices Index (RPI) is calculated. The changes could lead to a transfer in value from investors to the Government which Insight Investment estimates at £90bn and may have a big impact on pension schemes. Whilst the changes may not happen for 10 years, trustees and employers are likely to have only a short period in which to influence the outcome.

What is happening?

The Government has decided that at some point between 2025 and 2030 RPI will be changed so that it is calculated in the same way as another index, known as CPIH. On average, CPIH increases by around 1 per cent less each year than RPI[1].

This change will affect defined benefit pension schemes in two ways. Many pensioners currently receive pension increases in line with RPI. They will in future receive lower pension increases because RPI will be lower. This does not just affect current pensioners, but also active and deferred members of schemes with increases based on RPI who will receive lower increases in retirement.

The second impact is on scheme assets. Most defined benefit pension schemes hold Index Linked Gilts which provide returns linked to RPI. Many also hold RPI inflation swaps. Those schemes will suffer a fall in future returns because RPI will be lower. The value of those assets will therefore fall – in some cases quite significantly. Liability driven investment (LDI) strategies may also need to be restructured, incurring additional costs.

The impact on individual schemes and members will differ from scheme to scheme. Those with unhedged RPI liabilities may see a welcome funding improvement whilst those with hedged CPI liabilities are likely to see a drop in funding. However, all Index Linked Gilt holders will see a fall in the value of their investments, and all individuals with RPI linked pensions and annuities will see a reduction to their future benefits

Why is this change being made?

The UK Statistics Authority (UKSA) is responsible for producing official statistics and has a statutory obligation to produce the RPI every month. It has, though, repeatedly said that it considers RPI to be fundamentally flawed. Nonetheless, back in 2013, it announced it would ‘freeze’ the method by which RPI is calculated, rather than reform it – i.e. leave it alone, warts and all. The pensions industry has operated on this basis ever since.

However, following a report in 2019 by the House of Lords Economic Affairs Select Committee, the UKSA changed its position. It wrote to the then Chancellor and suggested that RPI should cease to be published.

What did the Chancellor decide?

The recently departed Chancellor, Sajid Javid, rejected the proposal to abolish RPI. Instead he decided that RPI would continue to be published but would be changed so that it is calculated just like CPIH. RPI would be CPIH in all but name, but the name matters.

The Chancellor’s approach means that Index Linked Gilt holders will see a value transfer from investors to the Government estimated to be around £90 billion. Unless investors mount a successful legal challenge or persuade the Government to take a different approach, they will have this change imposed on them. Holders of other RPI linked investments will see equivalent losses.

At the same time a pensioner with an RPI linked pension or an annuity could see a drop in their lifetime income which the Institute and Faculty of Actuaries estimates to be 10-15 per cent[2].

What if RPI was abolished?

Had the Chancellor agreed to the proposal to abolish RPI, the outcome could have been very different. The Treasury would be required by the relevant contractual terms to adjust returns on all Index Linked Gilts in a way which is just and equitable. It seems unlikely that the Chancellor could have decided it was just and equitable to move to returns based on CPIH without any upward adjustment to protect Gilt holders.

Abolishing RPI would also trigger provisions in most pension schemes which would require the scheme to find a replacement method for calculating pension increases. This would allow some schemes to protect pensioners from the impact of this change.

What should you do about it?

Many experts share the UKSA’s view that RPI is fundamentally flawed as an inflation measure and it may be that CPIH is a better index. However, the issue pension schemes are facing is not which is the better index. The issue is how the Government is proposing to deal with RPI’s flaws.

The consultation to be launched on 11 March is due to be about when and how this change will happen. It appears the Government is not intending to consult on whether to make the change. The question of whether this unilateral cut in asset values and pension benefits is the right thing to do is not on the table.

Trustees who will see a significant fall in the value of their assets due to this change, may want to consider whether they should do something to try to protect those asset values. Some trustees may also feel they would like to limit the impact of this change on their members.

Similarly, those employers who face a drop in scheme funding may want to stop the change happening.

However, the window in which it is possible to influence the outcome may be very short. If trustees and employers want the consultation to deal with the question of whether the change should be made at all, or made in full, they need to demand it soon. The appointment last week of a new Chancellor creates an opportunity for schemes to push for a rethink before the consultation starts. Those wanting to do so should write to Rishi Sunak before 11 March 2020. Otherwise it may be too late to challenge the scope of the consultation.

Anyone who wants to object also needs to respond robustly to the consultation and anyone brave enough to mount a legal challenge may need to move very quickly once a final decision is made.


[1] Source: Insight Investment “Proposed Changes to RPI” November 2019

[2] Source: Institute and Faculty of Actuaries response to House of Lords Economic Affairs Select Committee 25 July 2018