London – Thursday 10 January, 2013 – The National Statistician’s decision to introduce another new inflation index instead of overhauling the Retail Price Index (RPI) means that future pension payments will be higher than some employers were expecting, according to Towers Watson.

The consultancy says the decision is a reprieve for individuals with pensions explicitly linked to RPI – for example, it could mean that a £10,000 pension reaches about £13,400 after ten years of increases compared with £12,400 if the most radical change discussed had gone ahead. As such, it will add to the challenges faced by employers who must negotiate funding agreements with defined benefit pension scheme trustees this year.

Why deficits may now be bigger than employers had expected
John Ball, head of UK Pensions at Towers Watson, said: “This is not the outcome that most people were expecting. The National Statistician had said that her consultation was primarily about ‘statistical methodology and best practice’ and the ONS had already concluded that a formula used to calculate price increases for 27% of the RPI basket has an ‘upward bias’.
“Although there was too much uncertainty for the markets to have priced in the full change, some amendment to the main RPI had been anticipated by the markets and therefore ‘banked’ in the deficits that employers were expecting. Indeed, for some companies, this will have flowed through to their 2012 year-end accounts.

“The future inflation rates implied by the gilt market increased significantly on the back of this morning’s news, perhaps adding about 4% to the liabilities of a typical final salary scheme with RPI-linked pension increases, although the impact may change as market conditions settle. The resulting increase in pension deficits will depend on investment strategy and will be less for those schemes with large holdings of index-linked gilts.”

The decision not to change the RPI may be better news for employers whose schemes pay pensions linked to CPI. It does not alter the pensions they will have to pay out but does increase the income they can expect to receive from any index-linked gilts they hold.

John Ball said: “When the Government switched some pension increases to CPI, the impact on employers and scheme members varied according to how scheme rules were written. Making RPI more like CPI would have extended the gains to many more private sector employers and the pain to more members. Instead, the differences will largely be preserved, though schemes rules may again play a part in determining how some employers and members are affected by today’s announcement.”

The National Statistician’s decision
The Consumer Prices Advisory Committee recommended changing ‘the RPI itself’ and the National Statistician has reiterated that a formula used in RPI ‘does not meet international standards’. However, she stressed the value of allowing the existing RPI ‘to be used for long-term indexation and for index-linked gilts and bonds in accordance with user expectations’.

John Ball said: “The suggestion that a formula used in RPI has an ‘upward bias’ is not new. The statistical technique in question has been criticised on these grounds since at least the 1920s, long before index-linked bonds and pensions were issued, so there was always a question of ‘why change now?’ The impact that this feature of feature of the RPI has was magnified when the ONS changed the way it collects clothing prices in 2010. The suggested changes to RPI would have more than reversed the windfall gain that people with RPI-linked pensions got at the time; they will now keep it.”

What new inflation indices mean for pensions
From March, the ONS will publish two new indexes – RPIJ (the RPI basket but with different formulae, expected to produce a lower number) and CPIH (the CPI but including a measure of owner-occupiers’ housing costs and potentially further changes in future). Looking further forward, a paper discussed by the Consumer Prices Advisory Committee this week said: ‘It is recommended that ONS reviews whether any further additional indices may be required to meet users’ needs. For example, the consultation identified considerable interest in further development of the pensioner index currently produced by ONS’.

John Ball said: “We expect that most schemes providing RPI-linked benefits would only be able to switch to RPIJ for future accrual and not for benefits that people earned in the past, though it will vary according to how references to RPI in scheme rules are written and won’t always be clear cut. As employers already have the option of switching to CPI for new accrual to save money, and many have now turned off the tap altogether, this is largely academic. However, the renewed criticisms of RPI from the ONS may strengthen the resolve of any employers considering this move.

“The Government has previously said that it would look at whether CPI-linked pension increases should be based on a measure of CPI that includes housing costs. It has a few months to make its mind up but the impact should be relatively minor, at least in the short term.

“If a revamped pensioner index is produced, this could be noticeably higher than CPI at times when the things that pensioners spend more money on, such as heating, are getting more expensive while things they tend not to buy are getting cheaper. This might lead to calls for further changes to the rules governing pension increases further down the line.”