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What are 5 Things Trustees Should Know About the House of Lords’ Report on Inflation?

1. What’s happening?

In January, the Lords Economic Affairs Committee released a report on inflation which:

  • Recommended that the Statistics Authority fix “flaws” in the calculation of the Retail Price Index (RPI)
  • Advocated for the adoption of a single general measure of inflation within the next five years
  • Called for the Government to stop issuing new RPI-linked gilts and issue Consumer Price Inflation (CPI)-linked gilts instead

The influential Chair of the House of Commons Treasury Select Committee agreed with the Lords’ position. The report’s conclusions are not legally binding, but they have placed considerable pressure on the Government to consider amending RPI.

The average pension scheme would see funding ratios fall by 1% or more as a direct result of this reform.

2. What’s the difference between RPI and CPI?

The principal differences are:

  • The “formula” effect: RPI is an arithmetic mean and CPI is a geometric mean
  • Basket composition: RPI includes a broader range of goods and services, including certain housing costs

3. What are the potential implications?

If RPI were amended, the “wedge” between RPI and CPI could narrow by 0.30-0.40%, impacting:

  • Index-linked gilt holders: the value of index-linked gilts would fall
  • Pensioners: The rate at which RPI-linked pensions are increased would fall
  • Defined benefit pension schemes:
    • The present value of RPI-linked liabilities would fall
    • The value of RPI-linked hedges e.g. index-linked gilts and RPI swaps would fall

The net impact on a scheme will depend on:

  • Its mix of liabilities linked to CPI vs. RPI
  • The share of liability-driven inflation risk that has been hedged with RPI-linked instruments

We estimate the average pension scheme would see funding ratios fall by 1% or more as a direct result of this reform if it were implemented. Schemes with a large share of CPI-linked liabilities and significant RPI-linked hedging would suffer larger impacts.

4. Are CPI-linked assets available to purchase as hedges?

CPI-linked assets are much less liquid than RPI-linked assets, but liquidity has been improving:

  • Swap supply has started to come through from utility companies wanting to hedge away regulatory revenues linked to CPI
  • Some physical supply also exists through private debt placements coming from water companies and some corporate issuance

5. So, what next?

Trustees should be aware of the risks to their members and their schemes’ funding positions. Trustees could ask:

  • Their actuaries to estimate the impact on the value of scheme liabilities
  • Their consultants and (LDI) managers to estimate the impact on RPI-linked hedges

This is not the first time RPI has been reviewed. A similar consultation was performed in 2012 but ultimately no changes were made.

The adverse impact on index-linked gilt holders likely creates a further barrier to change, particularly now, amid Brexit uncertainty.

The Government is expected to respond shortly to the Lords report.