Knowledge Centre

RPI - RIP?

In this month’s Fiduciary Management Perspective, Charles Marandu FIA CFA, Director of SEI’s European Institutional Advice, discusses on the intention to move away from the Retail Price Index when calculating the statutory minimum level of deferred benefits and increases to pensions in payment in the private sector.

Background
In a written statement on the 8th July this year, the UK Pensions Minister, Stephen Webb announced the intention to move to a policy where the statutory minimum level of deferred benefits and increases to pensions in payment in the private sector would be calculated in reference to the Consumer Price Index (CPI) rather than the Retail Price Index (RPI). This followed the announcement as part of the first coalition government budget in June to make this policy mandatory for public sector pensions. The move should lead to a lower value of benefits and liabilities for defined benefit (DB) pension schemes on the basis that CPI is expected to be lower than RPI. Current estimates suggest that a pension paid in 20 years time could be 13% lower under CPI(1).

CPI vs RPI
Both CPI and RPI measure the average changes, month-on-month, in the prices of consumer goods and services purchased in the UK. The most useful way to think about both the CPI and RPI indices is to imagine a ‘shopping basket’ containing those goods and services on which people typically spend their money. As the prices of the various items in the basket change over time, so does the total cost of the basket. Movements in the CPI and RPI indices represent the changing cost of this representative shopping basket.

There are also differences between the RPI and CPI representative shopping baskets including:

• Items weighted differently
• Mortgage payments only included in RPI
• Weightings calculated differently - CPI: Geometric (lower), RPI: Arithmetic (higher)

The switch from RPI to CPI has been introduced as a cost saving measure for pension schemes, as it is anticipated that CPI with be lower in the future than RPI. Historically CPI has been 0.7% per annum lower than RPI(2).

 (1) Pensions Week Magazine, 12 July 2010     (2) Office of National Statistics, 2010

  The gap between RPI and CPI year on year

Source: Officer of National Statistics (ONS)
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The implications for corporate pension schemes

Uncertainty

The legislation required to implement this change has not yet been passed through parliament so there are a number of legal uncertainties which make it difficult to assess the full impact of the proposed changes. These include: the extent to which the rule will legally over-ride scheme Trust deeds where RPI is used, the extent to which member communications which have ‘promised’ an RPI linkage may be allowed to impose CPI instead and whether the policy will be implemented retrospectively or only prospectively for deferred members. Despite these uncertainties there are a number of implications that pension schemes should be aware of in order to prepare for the changes to be implemented.

Administrative
Pension scheme trustees should review their legal scheme documentation and communications to ensure they have a full understanding of the ‘promises’ that have been made to members and how their benefit increases are currently calculated.

Investment Policy
Pension fund investment policy should be designed with liabilities in mind. The best match for RPI linked liabilities historically has been RPI linked index linked gilts or RPI linked inflation swaps. A move from linking liabilities to RPI to linking them with CPI, would make these instruments imperfect in their ability to ‘match’ liabilities and will create demand for CPI-linked instruments. At this point in time the government has not communicated plans to offer any index linked gilts linked to CPI, but this might change in response to demand.

The introduction of a CPI linked physical supply would also initiate an increase in provision by investment banks offering CPI linked instruments. If this occurs pension scheme trustees may need to work with their advisers or Fiduciary Managers to ensure a new investment policy is designed that includes the CPI linked instruments available to match their liabilities.

In the short term, before the CPI linked asset market takes off, the implications for pension fund investment policy may be less severe than has been reported in the press. Actuaries are likely to continue to use RPI linked instruments to determine appropriate future expected CPI (e.g. by reducing inflation assumptions by 0.4%-0.75%). Therefore, changes to CPI liabilities might still be linked to RPI markets and RPI instruments would continue to hedge the CPI liabilities. In the longer term, as more reference CPI instruments become available, actuaries will be likely to start to use these directly as reference points for future expected CPI, leading to knock-on implications for investment policy.

Buy-in – Not a time to be hasty
The one exception to the view that the move from CPI to RPI is likely to produce minimal impact on scheme policy is in the case of decisions by pension funds to ‘buy-in’ some or all of their pension liabilities. Consider a scheme that has already bought in some of its liabilities with the premium paid based on an RPI basis. In a buy-in, in exchange for a premium covering a group of named members, an insurer covers the benefits required to be paid in the future and provides these payments to the pension scheme which retains responsibility and liability for paying benefits. The issue with this approach in relation to the change from RPI to CPI is two-fold:

Firstly, the buy-in premium paid by the scheme to the insurer in the past might now, in hindsight, look expensive if it becomes a legal obligation to pay CPI linked benefits. This is because, as we have mentioned, CPI is generally expected to be lower than RPI, lowering the overall liabilities/benefit payments due.

Secondly, although it is thought that in the long term CPI may be lower than RPI (see the above graph), there may be periods of time when this is not the case. This may lead to a potential mis-match between what is covered by an RPI linked buy-in contract and payment required to be paid to the members by the scheme.

In our view, in the light of these points, it may be sensible for schemes currently considering buy-in to wait until the legislation is more concrete or to consider other options for reducing risk. This could include opting for a ‘synthetic buy-in’ where the trustees retain control of the assets instead of locking into an inflexible agreement. In a ‘synthetic buy-in’ a risk controlled asset allocation is combined with derivatives to hedge out the principal liability risks in the scheme (interest rate, inflation and longevity). In this solution some basis risk would exist in terms of the inflation hedge being linked to RPI. However as CPI linked vehicles become more readily available, a scheme that has undertaken a synthetic buy-in should be able to roll the asset inflation exposures from RPI to CPI to match the liabilities.

Conclusions –Slowing the demise of DB
It is clear that the move from RPI to CPI will benefit many employers who are likely to see a decrease in their pension scheme liabilities. Based on the historic difference between RPI and CPI this is likely to be somewhere in the region of 5% - 15%. This reduction in liabilities and the resulting improved funding level, may encourage company sponsors to retain their DB scheme, at least for existing members delaying the demise of DB. If this is the result of the move from RPI to CPI in the corporate sector it will be a positive one for both employers and employees who are generally better protected in a DB arrangement than in a defined contribution (DC) arrangement.

Despite this positive result of the proposed change in the rules it could be argued that the government could have gone further in their indexation changes. As the Association of Actuaries has argued, it is perhaps surprising to know that the UK is the only country in the world to impose mandatory indexation of both deferred pensions and pensions in payment in DB schemes. No other parliament in the world has placed such an onerous obligation on private sector firms(3) and it can be argued that the approach has directly contributed to the speed of DB scheme closure in the UK. In 2008 both the Association of Consulting Actuaries (ACA) and the National Association of Pension Funds (NAPF) proposed to the then Labour government that a policy of ‘conditional indexation’ should be introduced for corporate sector pension schemes. This approach, seen for example in the Netherlands, would allow indexation to be granted to members only if the financial health of the scheme was sufficient to allow it. After a lengthy consultation it was decided that conditional indexation would not be implemented in the UK. We would argue that the latest move in indexation policy though perhaps not a big enough step, is a step in the right direction for corporate pension schemes and should ideally lead to some delay in the demise of DB. 

(3)Association of Consulting Actuaries paper, 18th February 2008

About SEI
As the first and largest global Fiduciary Manager, SEI is well positioned to assist UK pension schemes with timely decisions relating to their investment policy and the overall management of their pension scheme. Fiduciary Management is defined as a pension management solution which focuses on achieving the long term goals of a pension fund within a defined risk management framework by providing both day-to-day investment management and advisory services. By combining strategic advice, risk management and a Manager of Managers investment process, SEI can professionally assist pension schemes with the oversight and implementation of their pension fund assets.

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