Pensions experts predict RPI limbo for years to come

The proposed alignment of RPI with the housing variant of the consumer price index could see £100bn or more wiped off the value of pension scheme assets, with a 65-year-old losing 10 to 15 per cent of their income over a lifetime, according to analysis by Insight Investment.

Chancellor Sajid Javid announced the intention to merge the measures in September 2019, with a consultation due in January.

However earlier this month, Mr Javid announced that the consultation will be launched alongside the UK Budget in March, with a response expected before the parliamentary summer recess.

While the policy has been proposed in response to the UK Statistics Authority's condemnation of RPI as a legacy index and poor measure of inflation, experts say the move will hurt some schemes and pensioners if compensation is not provided.

RPI generally runs at about 1 percentage point higher than the CPI, and is currently 2.2 per cent compared with a CPI of 1.5 per cent.

Consultancy LCP has calculated that the change could swing defined benefit funding levels by as much as 10 per cent, depending on the wording of their liability promises and their investment strategy.

Schemes grappling with uncertainty

Such huge sums and the current state of limbo “means that pension schemes cannot assess with any confidence future rates of the RPI”, said Ian Mills, senior investment consultant at Barnett Waddingham.

“It affects many different aspects of running a pension scheme,” he added.

“The supply of index-linked gilts, even on the present RPI basis, has been inadequate to meet demand, while the supply of CPI-linked gilts is almost non-existent.”

According to Ian Neale, director at Aries Insight, this delay prolongs a situation that has been increasingly unsatisfactory for DB schemes.

He said: “As the chancellor has ruled out any change before 2025 at the earliest, whether the next government – following the general election due in late 2024 under the Fixed Term Parliaments Act, unless it is repealed – will be bound by any decision this government makes is an open question.”

Real prospect of legal action

The government could also face a backlash from some pension schemes depending on its response to the consultation, experts warned.

Mr Mills said: “It’s quite likely that some parties will consider challenging any government decision not to compensate bond holders – with around £700bn of index-linked gilts outstanding, the sums involved are so vast that if even if there’s only a slim chance of success, legal action may well be considered.”

He explained that the calculation of inflation statistics has changed over time, and sometimes this has benefited bond holders.

“For example, there was a change to the methodology in 2010 that led to higher rates of RPI, favouring bond holders. Bond holders didn’t complain about that change,” Mr Mills added.

A more likely scenario, predicted Janet Brown, partner at Sackers, is that the government – wanting to retain its reputation as a debt seller – will want to resolve the inflation-linked gilts issue.

“It will do something to head off the situation, either by giving compensation or having a notional RPI on such investments,” she said.

Some RPI reforms have already been priced in, according to Derry Pickford, principal consultant at Aon’s asset allocation team.

He said: “The price of index-linked hedging assets has likely fallen in value already because of the possibility of changes. We estimate that the long end of the forward break-even curve shifted by about 20 basis points because of the announcement.

“The UK 2068 bond famously fell 14 per cent over the two trading days after the announcement, but probably only around half of this can be attributed to the chancellor’s letter.”

Pension schemes to rethink derisking activities

Given the potential for change, schemes implementing or adding to their liability-driven investment programmes may want to reassess the levels at which are they are comfortable buying inflation protection, warned Niren Patel, LDI portfolio manager at Aviva Investors.

He added: “Schemes looking at insurance transactions – of which there were record volumes in 2020 – may reconsider this type of activity as there is the potential for an increase in insurers’ costs to protect against an adverse consultation outcome.”

Stephen Scholefield, partner at Pinsent Masons, noted that trustees and employers should now be thinking about how any change could affect them, so that they are well placed to respond to the consultation – “especially if they stand to be adversely affected”.

He added: “Those who are thinking about certain derisking activities should also keep this issue in mind. For example, giving members the option to swap RPI increases for something else has a new dynamic to it.”