What difference can switching to CPI make?

However, over the past 10 years other measures of inflation have emerged. The most prominent of these is the consumer price index. It uses a slightly different basket of goods, but more importantly is based on a better underlying mathematical methodology.

That is a view that is clearly shared by financial statisticians – not least the Office for National Statistics, which regularly makes it clear that the old RPI does not meet current international standards.

A few years ago, the ONS talked about changing the way RPI was calculated to bring it in line with the methodology used for CPI.

But for reasons best known to the ONS it didn’t, although it did introduce yet another index, the RPIJ, which used the CPI methodology.

Trustees need to ensure that the correct benefits are paid, not to try and maximise the benefits payable to members

This may all seem a bit technical, until you realise that this difference in methodology means CPI will usually be lower than RPI – probably by around 1 per cent a year.

That doesn’t sound like a lot, but that small difference can build up over time.

Many members of defined benefit pension schemes are entitled to a pension increasing in line with inflation. 

A difference of 1 per cent a year over the lifetime of a pension might equate to a difference in value of around 12 per cent.

And a difference of 12 per cent in the value of pension obligations could be the difference between a big deficit and no deficit at all.

Not surprisingly, sponsoring employers are now looking very carefully at which index is used to determine pension increases.

Why do some schemes stick to RPI? 

Some schemes link pension increases to statutory minimum levels. The government has already switched to CPI for calculating these.

But other schemes give trustees an element of discretion about how to measure inflation – often scheme rules call for the use of some suitable index.

Despite the fact that consensus would clearly indicate CPI is more suitable, many scheme trustees seem reluctant to change.

Some have attempted to argue that use of RPI is established practice, and while the index remains in existence they see no reason to change.

The more common argument is that use of CPI will lead to lower increases – which cannot be in members’ interests.

I would argue that trustees need to ensure the correct benefits are paid, not try and maximise the benefits payable to members.

Compounding generation DB’s luck

It is a fact that members of DB schemes have done very well for themselves. In almost every case, the value of the pension members have built up is materially greater than the expected value of that pension at the time they were actually working.

So there’s absolutely no reason to compound that luck by giving them generous pension increases on the basis of outdated mathematics.

In practice, a failure to adopt the CPI measure carries a significant cost for sponsoring employers at a time when they are already under pressure from the strains of funding pension scheme liabilities.

Given that CPI is based on a sounder methodology than the historical measure of RPI it seems wrong to shackle sponsoring employers with higher liabilities than necessary.

As a result, it is right to question if we really need to add to the current strain by giving the final salary generation more generous increases than they are reasonably entitled to.

John Broome Saunders is actuarial director at Broadstone