With the change from RPI to CPI indexation, Graeme Troy takes a look at what this means for pensions
Any change to the rules governing pensions is bound to be met with trepidation. Little wonder – it is rare for these changes to result in good news for individuals. But an announcement by pension minister Steve Webb has also resulted in a degree of unwelcome confusion for the industry itself.
Mr. Webb said in July that the way in which inflation adjustments to private sector pension schemes are calculated is to change. At first glance, the move – from the retail price index (RPI) to the consumer price index (CPI) – looks like a mere technical adjustment. But look a little closer, and it is clear the change has a number of implications.
It is likely to reduce employers’ liabilities. This is important, because the future of the defined benefit pension has been in jeopardy for years. Consultancy firm AonHewitt recently estimated that there was a shortfall of £74bn in the 200 largest final salary schemes when comparing scheme assets versus liabilities.
For reasons of affordability, many final salary schemes are closing to new members, but because of the fundamental difference in the way CPI and RPI are calculated, the proposed changes could reduce future funding costs. Historically, the CPI measure of inflation has typically run 0.8% lower than RPI inflation, as the latter includes measures for house prices and mortgage payments.
An important point is that the change is to the regulatory minimum for increases. Schemes are free to offer more than the minimum, and some already do.
Implications are further clouded by the variety of scheme rules governing individual pension schemes. In some schemes, rules state that inflation-based pension increases will be in line with the statutory link. In such cases the proposed switch would be automatic. But many private sector pensions are based on the RPI, and some scheme rules specifically refer to this. Aon’s research revealed that 58% of defined benefit schemes are required by their rules to increase pensions that are already in payment in line with RPI.
The Pensions Act 1995 protects the existing value of pensions, so if a switch is not automatic, members will need to be consulted before any change to the rules.
The change from RPI to CPI will have a big effect on the retirement income of pensioners. The cumulative impact of a potential reduction in proposed income of 0.8% per year could knock upwards of 15% off the value of pension payouts.
As scheme members are likely to resist wholesale changes to inflation-linked benefits, many schemes could be compelled to keep paying RPI unless legislation – in the form of a statutory override – forces changes to the contractual terms.
The change may already be having implications for the bond market. Because of the way the pension fund industry works, Britain issues a higher percentage of index-linked government bonds than any other major country. Funds consider it prudent to invest in a way that matches assets with future expected liabilities as closely as possible. As the asset class best matching these liabilities is longer-dated RPI-linked gilts, this has resulted in strong demand. Around a fifth of all outstanding gilts are linked to RPI.
The proposed switch to CPI may result in the development of a new market for CPI-linked bonds. That could mean the demand for existing RPI index-linked bonds falls in future, and all else being equal, yields on these bonds would increase.
Indeed, there are indications that the government’s planned changes are already having an effect. Over the past six months, longer-dated index-linked bonds have underperformed their shorter-dated counterparts. While ten-year yields have rallied by an average of 30 basis points, yields for bonds at the long end of the curve are practically unchanged.
This could indicate that the pension funds who are by far the biggest buyers of long-dated RPI-linked gilts lack confidence in their long-term future usefulness. It suggests that pension funds have put their bond buying programmes on the back burner for the time being. At the very least, it is an indication that more clarification is needed.
But given that some schemes may opt to continue to pay RPI-linked benefits, and that the majority of existing benefits will still be linked to RPI, we may see a two-tier index-linked market where supply would be met with relevant levels of demand for both types of inflation linked bond.
Looking ahead, legislation needs to be carefully drafted, and timelines clarified. The changes should ultimately reduce some scheme liabilities, but would reduce most scheme members’ benefits. However, there are still many obstacles to overcome until we reach that point.
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