The impact of RPI reform on pension schemes and their managers

On 11 March 2020, HM Government and the UK Statistics Authority (UKSA) launched a consultation paper (the CP) on the UKSA's proposal to reform the Retail Prices Index (RPI) Methodology. The consultation closes on 21 August 2020.

The CP acknowledges that the proposed change to the RPI methodology would see its annual measured rate of inflation being lower, on average, by 1% per annum. This would have a major impact on the UK index-linked gilt market, financial contracts referencing the RPI and pension schemes which use the RPI, for example, for revaluation and pension increases.

According to an estimate by Insight Investments, as well as reducing the pension fund benefits received by millions of people up and down the country, the change could result in a transfer of wealth from index-linked gilt holders to the UK government of around £100bn. For some schemes/managers, RPI reform could have a significantly greater impact than LIBOR reform.

Trustees, managers (in particular, Liability Driven Investment managers) and other relevant stakeholders will wish to engage with the CP to seek to ensure that any detrimental impact of the change, including through wealth transfer on index-linked gilts or value transfer on RPI-linked financial contracts, is minimised and a fair outcome reached.

It may be that, in a similar way to LIBOR reform, a spread adjustment can be applied to the amended rate to avoid these risks. However, this will involve industry and government consensus on the appropriate spread and where and how it should be applied. It must be hoped that a pragmatic and fair solution can be reached but the industry will need to galvanise in order for this to be achieved.

We are working closely with firms as they engage with this process and would be pleased to discuss further.

What is the proposed RPI methodology reform?

In seeking to address shortcomings of RPI (including in the index formulae it uses to aggregate some price changes, the treatment of housing costs, population coverage, weights, classification and geographic coverage), the UKSA made the following two recommendations:

1. that the publication of RPI should cease; and

2. in the interim, the RPI should be aligned with the Consumer Prices Index including owner occupiers' housing costs (CPIH).

The Bank of England considered the second recommendation to constitute a fundamental change in the index which would be materially detrimental to the interests of the holders of relevant index-linked gilts (2½% IL 2020, 2½% IL 2024 and 4 1/8% IL 2030). This means the consent of the Chancellor of the Exchequer is required for the second recommendation to be implemented by 2030.

In a letter of 4 September 2019, in relation to the first recommendation, the then Chancellor stated he was not minded to promote legislation that would remove the requirement for the UKSA to produce and publish the RPI.

In relation to the second recommendation, the Chancellor was unable to consent on the information available at the time.

The UKSA is now only minded to implement its second recommendation and is consulting with the government on:

• technical issues concerning the implementation of the proposed change to RPI methodology;
• timing - including whether the proposed change might be implemented at a date other than 2030 (and, if so, when between 2025 and 2030); and
• broader impacts of the proposed changes.

How will the RPI methodology change?

The CP sets out details of how the RPI methodology will change, which is by bringing the methods and data sources from the CPIH into the RPI.

From the implementation date, the RPI index values would be calculated using the same methods and data sources as are used for the CPIH. The CP acknowledges that the proposed change to the RPI methodology would see its annual measured rate of inflation being lower, on average, by 1% per annum (though this can vary over time).

What are the areas under consultation?

1. The technical approach: is the suggested approach to bringing CPIH methods and data sources into the RPI statistically rigorous?

The UKSA's proposed technical approach to transition is by introducing CPIH methods and data sources into the RPI through a so-called "chain link".

Under a "chain link", the growth in the new series under the new methodology (with CPIH methods and data sources brought in) is applied to the long-run series based on the old methodology (current RPI). This approach is used fairly widely for introducing new methods and baskets into indices.

The CP seeks views on how to bring CPIH methods and data sources into the RPI, specifically asking whether its suggested approach (set out in more detail in section 4 of the CP) is statistically rigorous.

2. Timing: what will be the impact of implementing the proposed RPI methodology change on holders of index-linked gilts?

Section 5 of the CP seeks information on the impact of the change on holders of index-linked gilts and the indirect effects on the gilt market.

The CP acknowledges that the direct impact of the Chancellor consenting to the UKSA's proposal would be that HM Treasury may be required to offer to redeem outstanding relevant index-linked gilts. This would be a direct cost to the public finances, the scale of which would depend on when the change happens (as this dictates how many relevant gilts are outstanding) and whether their holders choose to exercise the redemption.

A change to the methodology of the RPI that, on average, lowers its measured rate of inflation, would reduce the debt interest and principal that the government pays on the entire outstanding stock of index-linked gilts. The net effect of these potential direct costs and benefits is uncertain, and the CP seeks further information to understand the impact more clearly.

The CP acknowledges the potential impact of the proposed RPI methodology change on holders of index-linked gilts and the gilt market more broadly, including on those such as pension schemes using them to hedge RPI-linked liabilities. The government and UKSA acknowledge that a change to the methodology for the RPI will affect both the assets and liabilities of holders of gilts, the outcome varying by investor.

3. What will the broader impacts of the proposed change be, including on financial contracts?

The RPI is used widely in the UK economy, including to uprate certain taxes, changes in rail fares, and to determine the rate of interest on student loans. In the private sector, the CP acknowledges that the RPI is used in some wage agreements, to uprate certain pension payments (particularly DB pensions), in calculating rent increases for some leasehold properties and in financial markets.

While neither the Chancellor nor the UKSA are likely permitted to take into account the broader impact of RPI reform in their decision making processes, there is an acknowledgment that they do not have full sight of the use of the RPI in the economy, including in financial contracts, and that the change to the RPI methodology could have unintended consequences on the economy, financial markets or certain groups of RPI users.

As such, Section 6 of the CP asks respondents to highlight these wider impacts so that the government and the UKSA can have full sight of them.

Following the RPI methodology reform, only the headline RPI index and growth rates will be published. Lower level or supplementary RPI indices will no longer be published. The ONS will provide guidance on CPIH supplementary indices which could be used as alternatives. Those that best map to the RPI supplementary indices are suggested in the CP.

The CP also seeks information on which lower level or supplementary RPI indices are currently used, what they are used for, and what guidance users of these would find most helpful.

How do I respond to the CP?

Respond via the e-consultation platform, email or otherwise in writing, as set out here.

The consultation will close on 21 August 2020.

HM Government and the UKSA have said that they will respond to the consultation before the Parliamentary summer recess.