Recent attention has been to the narrowing of the gap between the Consumer Prices Index (CPI) and the Retail Prices Index (RPI). It was just 0.4% in the year to September 2011 (5.2% versus 5.6%). With the gap being less than the 22-year historical average of 0.7% pa and forecasts as high as 1% pa, press commentary was on how DB scheme sponsors would not benefit as much had been hoped from the Government’s switch from RPI to CPI as the basis of statutory revaluation of deferred pensions and indexation of pensions in payment.
However, the Office for Budget Responsibility’s recently-published “Working paper No. 2: The long-run difference between RPI and CPI inflation” explains in some depth why we should be expecting the “wedge” between CPI and RPI not only to reach previous forecasts but to exceed them. The paper argues that the gap could average between 1.3% pa and 1.5% pa, double what it has been in the past.
The reasons are complex, but one key element is that a change made in January 2010 to the way the prices of clothing are collected will increase the “formula effect” from about 0.5% pa to between 0.8% pa and 1.0% pa. (The formula effect recognises a difference in the way the thousands of prices that are measured each month are combined when compiling the RPI and CPI indices and, in particular, the impact of consumers substituting different varieties of goods and services as prices change.)
If the wedge between CPI and RPI will grow as quickly as is now being forecast, the implications are numerous:
- Even where DB schemes are already allowing for the change in statutory minimum revaluations and indexation, deficits may not be as bad as was thought and their funding plans may now be too cautious (but for the fallout from the Eurozone debt crisis). They may also be paying out too much by way of cash equivalent transfer values.
- Scheme sponsors could also benefit from another windfall gain in being able to report lower liabilities on their balance sheets.
- Members, of course, will not see their pensions increase as quickly as they may have expected.
- Given the Government has refused to issue CPI-linked bonds in 2012, the pricing of CPI-linked annuities is likely to remain unfavourable, ie annuity prices will not fully reflect the expected differences between RPI and CPI. So, those DB schemes with CPI-linked benefits that were thinking of buying out through an insurance company may be well advised to put their plans on hold for a while.
- On the political front, the OBR has just upped the ante in the unions’ appeal against the High Court’s ruling that the Government was acting lawfully when it decided to switch to using the CPI as the basis of indexation for public sector schemes.
Was this September’s 0.4% gap betweeen CPI and RPI just the thin end of the wedge?
