Each week we seem to get more information about inflation, and yet there is still so little clarity!
Market inflation expectations have tumbled, but many commentators say it will bounce back, and the way inflation is measured is up in the air due to the current consultation on reforming the familiar RPI index. I welcome the decision, announced last week, that this consultation period will run for an extra four months. I think it’s really important that people respond, and in this blog I will explain why, and I will explore what might happen next.
Many pension scheme members may be surprised to learn that up to half of the value of their pension is tied up in the annual increases that aim to protect against rising prices. Private sector Defined Benefit pension schemes in the UK have around 85% of their liabilities linked to inflation and, of those, more than three-quarters are RPI-linked.
So RPI is really important. And therefore, so is the current Treasury/UKSA consultation (now closing 21 August 2020) regarding amending the formula for RPI such that it becomes the same as the CPIH formula. The key outcomes of the consultation will be both how and when such a change is implemented. With regard to “when”, the key options being discussed are with effect from either 2025, or 2030.
50:50 - there will be winners and losers
Whilst private sector pension indexation is one of the key uses for RPI, it is also used for a variety of other purposes, including increases to regulated rail fares and repayments on student loans. The other key purpose is paying interest on index-linked gilts – which are predominantly held by UK pension schemes. This is where things can become circular if you are not careful.
Given the current market turmoil, due to Covid-19, pension schemes and sponsors are going to be particularly sensitive to further pressure on pension scheme deficits – so what is the impact on pension deficits of the consultation options? Unfortunately, it’s not at all straightforward.
Some schemes would be better off if the change in the RPI formula was made sooner, say 2025 (most notably if they pay a lot of pensions with RPI increases but they don’t hold many index-linked gilts). Conversely, some pension schemes would be better off if the date was deferred until 2030 (for example if they have CPI-linked pensions, but hold RPI-linked assets).
Let’s ask the audience
I recently had the pleasure of chairing a webinar (still available to stream) to discuss the future of RPI with speakers from the Office for National Statistics (who are essentially running the consultation) and LCP. Over 200 guests were registered, including pensions managers, pension trustees, lawyers and of course actuaries.
As this is such an important matter, it surprised me that, during a webinar poll, the majority of responses were for not responding to the ONS consultation (83% of those who actively expressed a preference). Although looking at the statistics more closely, two-thirds of people hadn’t made up their mind about whether to respond. With the deadline extended, now is the time to think about what response you would like to submit. (Let’s face it, getting a response signed off in the first three weeks of August simply isn’t going to happen!)
On the asset side, I hear a lot of talk that holders of index-linked gilts could be eligible for “compensation” from the Government, particularly if the date of RPI’s transition is 2025. It’s not clear what the basis for this compensation would be, but certainly pension schemes – and pension scheme members with RPI-linked increases – could potentially be huge beneficiaries of this if it happened.
So, on one level, it was even more surprising that our audience didn’t think compensation for holders of index-linked gilts was appropriate. Many more expressed a preference in this poll, and they voted 2 to 1 against compensation being given. At a deeper level, perhaps they felt that there was no real justification for compensation in these circumstances?
Phone a friend: What do I expect to happen next?
Everyone in pensions – companies, trustees, and members themselves – should be concerned about the future of inflation. The issues surrounding RPI as a flawed measure of inflation have been well covered in previous blogs, including the one written by my good friend Jonathan Camfield here. As such, it now seems clear that RPI will be transformed into a much better economic measure of inflation, which much more closely resembles the current CPI measure.
The questions are how, when, and whether the market has got it right. Sticking my neck out, my current expectations for the long-term are:
- The effective date of the change will be 2030, although my personal view is that fixing the issue sooner would help get UK plc back on its feet more swiftly;
- Whatever the date, there will be no compensation granted to holders of index-linked gilts, even though it may be demanded through legal proceedings; and
- The current low levels of future inflation implied by the market will prove to be incorrect in the long-term, due to Covid-linked stimulus packages from Governments around the world.
These are just my predictions, it will be interesting to see what happens in practice.