Risks and opportunities coming from RPI reform

This followed a report in January 2019 from the House of Lords’ Economic Affairs Committee that found the UKSA is at risk of being in breach of its statutory duties by refusing to correct an error that it openly admits exists in the RPI.

This change is not a government decision, and so should not be subject to political uncertainty. There are two consultations that are due to be held in January 2020, but these are about whether to bring forward the change to 2025 and the transition process – importantly, not about whether the change should happen.

There may be opportunities for pension scheme sponsors and trustees to work together, and adapt their inflation-hedging strategies to better protect the scheme against any future market sell-off

Inflation change to affect assets and liabilities

On an average annual basis, the CPIH is expected to be around 1 per cent lower than the RPI – this is a big difference and means:

• Pension scheme members with RPI-linked increases will expect to get lower pensions from 2030 than they otherwise would have had.

• If the scheme increases are mainly RPI-linked and this is only partially hedged (many schemes are in this situation), such schemes are likely to see a net financial gain from the change, as assets values will not fall to the same extent as the drop in value of future benefits.

• If the scheme increases are mainly CPI-linked, and RPI instruments are in place to hedge this (for example, index-linked gilts), then such schemes are likely to suffer a net financial loss. This is due to the fact that CPI-linked benefits will not change, but the RPI instruments would be expected to fall in value to reflect the lower expected levels of the RPI.

Putting it together, there is still a lot of uncertainty around what this will mean for actuarial funding valuations, company accounting and long-term funding targets. Depending on your scheme’s benefits and investments, and as reported in LCP’s autumn report for corporate pension scheme sponsors, this change could improve your funding position by up to around 10 per cent, but it could also lead to a 10 per cent worsening.

We also expect there to be a change in prices charged by consolidators and buy-in and buyout insurers when taking on RPI-linked benefits, potentially reducing the ultimate cost over the long term.

An opportunity for schemes and sponsors

The response of index-linked gilt markets to the change was unexpectedly muted. Some of the potential reasons for this are that the market:

• had already priced this in;

• believes that ‘compensation’ will be paid to index-linked gilt holders (or other users of the RPI), or provided in the form of a fixed addition to RPI inflation from 2030;

• is primarily driven by supply and demand, which may not have changed;

• is more driven by other factors, including Brexit, uncertain political developments and recession risk.

In light of this response, there may be opportunities for pension scheme sponsors and trustees to work together, and adapt their inflation-hedging strategies to better protect the scheme against any future market sell-off. This is particularly the case where the pension scheme has CPI-linked liabilities beyond 2030.

Scheme sponsors should also consider this issue carefully if they are involved in any significant pensions action – this includes the buying or selling of index-linked gilts or similar swaps, buy-ins and buyouts, changing the index used for future pension increases, projects to equalise guaranteed minimum pensions, liability management exercises such as offering members a transfer value or a pension increase exchange, as well as needing to factor changes into long-term targets and journey planning.

Over the short term there is a pressing need for a number of company directors to set inflation assumptions as part of their annual corporate reports. At present, there are no market precedents and market practice is not yet established.

As a result, companies and their advisers will need to make judgements over what is and is not already priced in to the market, as well as what changes are likely to happen in the future.

This is no easy feat, and there is a risk that this decision could result in material differences in pension disclosures, which could have a far-reaching impact on a company’s disclosed results.

Jonathan Griffith is a partner at LCP