RPI 2.0 – ONS consultation on changing the index

Introduction

Pensions trustees could be forgiven for taking a deep breath and thinking “here we go again” as the ONS consults on making changes to RPI.

Following Government announcements in the summer of 2010, CPI replaced RPI as the statutory minimum for increases and revaluation in both public and private sector DB pension schemes from 1 January 2011. The ONS has now published a consultation on changing the methodology for calculating RPI, putting forward four possible options. The consultation closes on 30 November 2012.

In this Alert:

• Key points
• Background
• The differences between RPI and CPI
• Consultation options
• Conclusion

Key points

• The ONS has published a consultation on making changes to RPI, with the aim of implementing any changes in March 2013.
• As well as differences in the basket of goods, RPI and CPI use different formulas to calculate average prices. This results in a difference of up to 1% between the two indices and is known as the “formula effect”.
• The consultation paper identifies four different options for addressing the formula effect.
• We anticipate that, as happened on the switch to CPI, there may be scheme rule lottery as to the degree to which any changes made to RPI will apply.

Background

Before the statutory switch to CPI, occupational pension schemes were required to use RPI for increasing pensions in payment and during any period of deferment. Those schemes which specified RPI in their rules have retained this measure of inflation, while schemes which merely cross-referred to the statutory requirements have moved to CPI automatically.

The ONS has now proposed changes to RPI which if brought into place, are likely to make RPI more akin to CPI.

The differences between RPI and CPI

The main differences between RPI and CPI are:

• The population base – the RPI excludes very high and low income households and so CPI covers a wider population;
• Basket of goods (known as the “commodity coverage”) – the CPI excludes owner occupiers’ housing costs1;
• Different formulas are used to combine prices – it is this last difference which is the main focus of the consultation.

RPI and CPI use different formulas to calculate average prices. The consultation notes that there is dissatisfaction with the arithmetic approach (both the “Carli” and “Dutot” methods) used by RPI in calculating averages. In contrast, CPI uses a geometric (mainly “Jevons”) approach. This results in a difference of around 1% between the two indices and is known as the “formula effect”.

Consultation options

The consultation paper identifies four different options (three of which would reduce the formula effect), with the aim of implementing any changes in March 2013. The options are:

• no change – so retaining the formula effect;
• change one particular approach to averaging clothing prices – it is for this category that the difference between CPI and RPI formulas has the greatest effect;
• change one particular approach for averaging changes in prices for all categories – this would reduce the formula effect, although some difference between CPI and RPI would remain; or
• change the RPI so that its formula aligns fully with those used in CPI – this would remove the formula effect although differences would remain (because of the different coverage, weights and scope used by the indices).

Conclusion

The proposed changes to RPI are designed to make RPI more like CPI. If implemented, this is likely to reduce increases to pensions2 in the future and therefore scheme liabilities for the schemes which retained RPI. However, many schemes hold index-linked gilts as investments as part of liability matching investment strategies. Many of these gilts will also be affected by the change to RPI so that, although liabilities may reduce, so may the value of scheme assets.3

We anticipate that, as happened on the switch to CPI, there may be a scheme rule lottery as to the degree to which any changes made to RPI will apply. For example, some scheme rules allow a new index to be selected, if the index they currently use is materially or fundamentally changed.

1 This was one of the reasons the Government considered it was suitable for increasing pensions (as pensioners have normally paid off their mortgages)
2 Both in payment and in deferment
3 In addition, some RPI linked gilts (maturities 2013-2030) allow redemption if there is a “fundamental change” in the index