iangunn Feb 1st, 2021

On the same day the Chancellor published his Spending Review, 25th November 2020, HM Treasury published its response to the consultation on reform to the Retail Prices Index (RPI) methodology. This was somewhat overshadowed by other news events.

The methodology is to be changed by ‘bringing the methods and data sources of CPIH into the RPI’. This means including owner occupiers’ housing costs in the RPI and altering the method of calculating the published rate of inflation, which RPI systemically overstates.

This is not a merger of the two indices. The ONS will continue to calculate and publish separately both the RPI and CPIH indices and growth rates. However, it will discontinue the supplementary indices such as RPIX, and sub-indices of the RPI, at the point when the proposal is implemented (see below). This means only an ‘all-items’ RPI index and growth rates will be published.

The Chancellor has decided that, in order to minimise the impact of this change on holders of index-linked gilts, he will be unable to offer his consent to it before 2030. This is because there are early redemption clauses in the affected index-linked gilts which, if exercised, would result in a direct cost to HM Treasury. This decision was made despite the findings of the consultation that investors would be highly unlikely to exercise such an option given current market prices of gilts (exercising the option would almost certainly lead to capital loss for investors).

After 2030, the Bank of England considers that the proposed change will not have a materially detrimental impact on the interests of investors in index-linked gilts.Accordingly, the ONS will be legally and practically able to implement the changes to the RPI in February 2030.

As well as index-linked gilts, the RPI is currently used in a wide range of private sector financial contracts and instruments. Network Rail, for example, currently has around £19bn of index-linked bonds outstanding. There are also periodical payments of damages linked to the RPI, and many pension schemes have RPI-linked benefits.

The outcome of the change will be a reduction in the measured rate of inflation compared with what the RPI would have produced. The net effect is expected to be to narrow (or eliminate) the gap between RPI and CPI.Following the transition, monthly growth rates for the RPI and CPIH will be the same: annual growth rates will converge after year 1.

The impact of the change will therefore be to reduce the level of income that owners of RPI-linked assets can expect to receive and, in the process (other things being equal) reduce the capital value of such assets.

This change will have an adverse impact on defined benefit pension schemes. The Pensions Policy Institute (PPI) estimates that, for an individual who is 65 in 2020, the average reduction in lifetime pension income post-retirement could be 4% for a female and 5% for a male. However, according to the same estimates, the overall effect is likely to be more detrimental to women since, on average, they have longer life expectancy than men.

Defined benefit pension scheme members with benefits linked to the RPI who have ceased contributing to the scheme, but not yet retired, are likely to be worst affected. That is because increases to deferred benefits and increases to pensions in payment will be lower than would otherwise have been the case.

On the positive side, the change will remove the government’s ability to ‘index shop’, i.e. no longer being able to choose the RPI for revenues that accrue to the exchequer whilst selecting the CPI for expenses it incurs.

If you are left wanting more, here is the paper published by HM Treasury.

Ian Gunn

January 2021