RPI – No change

Introduction

CPAC was asked to consider and comment on the recommendations the ONS developed following their October 2012 consultation on changing the methodology for calculating RPI. This consultation put forward four possible options – and raised the spectre of RPI morphing more closely into CPI – with the potential for reducing inflation protection for both pensioners and bond holders.

The CPAC has today published a Summary Note on their decision – there will be no change to RPI.

In this Alert:

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

Key points

• There will be no change to RPI.
• But, from March 2013, we will have an additional inflation measure – “RPIJ” to add to CPI, CPIH (which includes housing costs) and RPI.
• The consultation arose because, 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 identified three different options for addressing this formula effect to a greater or lesser extent. But despite concluding that the formula used to calculate RPI is “unsuitable”, CPAC have recommended no change.

Background

Any of the proposed changes to RPI identified in the consultation would have made RPI more like CPI. This would have been likely to reduce increases to pensions in the future and therefore scheme liabilities for the schemes which retained RPI.

In addition, many schemes hold index-linked gilts or other RPI linked investments as part of liability matching investment strategies. These investments would also have been affected by the change to RPI and schemes need no longer be concerned with the potential consequences.

The differences between RPI and CPI

As well as using a different basket of goods and using a different population base, RPI and CPI use different formulas to calculate average prices. CPAC acknowledges in its Summary Note 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”.

Despite concluding that the statistical properties of Carli meant it was unsuitable for RPI, CPAC have decided to retain RPI unchanged.

Conclusion

CPAC’s decision not to tinker with how RPI is formulated will be a relief for existing pensioners who have retained RPI as the method by which their pensions are increased. Many in the pensions industry will also welcome the news. Trustees holding RPI linked investments will be pleased with this decision as the value of their assets won’t be diminished as a result of the expected change.

The development of the proposed new index, RPIJ (based on Jevons), will be awaited with interest. This will mean that in future there will be four key indices in use – CPI, CPIH (which includes housing costs), RPI and RPIJ. It is unclear at present what this additional index would be used for, although it would be available in future as an alternative to RPI.

Today’s decision confirms what we had suspected all along, that there is no one right answer to inflation measurement.