The great
inflation
robbery?
 

How trustees could be
caught out by the end of RPI

While Brexit is set to dominate the political agenda again in 2020, for the pensions industry there is another major shift on the horizon that could have a profound impact on funding levels and outcomes for members.

Chancellor Sajid Javid announced in September that the government intended to consult in January on changing the methodology for the retail price index with the aim of bringing it in line with the consumer price index, including owner occupiers’ housing costs. The government aims to finalise a plan before the end of the 2019-20 financial year.

The outcome will affect the price of index-linked bonds, pension fund liabilities, derisking strategies, annuity prices and, ultimately, the amount some retirees can expect to be paid from their defined benefit schemes.

According to Insight Investment – one of the biggest managers of fixed income and liability-driven investment mandates in the country – the move could wipe £90bn from the value of the UK index-linked gilts market. On the day of Mr Javid’s announcement, the Financial Times reported that some parts of the RPI market had fallen in price by as much as 10 per cent.

Robert Gall, head of market strategy at Insight, says the gilt and inflation swap markets have only just begun to price in the effect of the changes. “After 2030, when the change is expected to happen, if we look at the forward price, the market has probably moved by 25 basis points or so. It’s priced in some of the change, but not all.”

“The government runs the risk of punishing those who have been prudent, with a well-funded and well-risk-managed scheme, whereas those that have left risks unmanaged could be rewarded”
Ian Mills, Barnett Waddingham

Analysis by Barnett Waddingham suggests schemes linked to RPI are likely to see a significant reduction in liabilities, by 10 per cent or more in some cases.

However, given the lack of a market in CPI or CPIH assets, many schemes that have moved to CPI for their liabilities are still using RPI assets as an inflation hedge. These are likely to be the worst hit by the transition to CPIH, according to Barnett Waddingham.

The consultancy found that, assuming a 1 per cent annual fall in the future inflation measure – as is widely expected to happen when the change takes place – such schemes could see funding levels fall by as much as 12 per cent.

Ian Mills, senior investment consultant at Barnett Waddingham, said the January consultation could have “seismic implications” for DB schemes.

“The government runs the risk of punishing those who have been prudent, with a well-funded and well-risk-managed scheme, whereas those that have left risks unmanaged could be rewarded,” Mr Mills said. “The government needs to be careful about moral pitfalls like this, as setting such a precedent can dangerously affect trust and behaviour.”

RPI has not been an official national statistic since 2013. A decade earlier, then-chancellor Gordon Brown moved the UK’s official inflation target to CPI. 

John Pullinger, the UK’s official national statistician until his retirement last year, described the measure in 2018 as a “very poor measure of general inflation, at times greatly overestimating and at other times underestimating changes in prices and how these changes are experienced”.

Government to reduce index-linked gilts

The UK’s stock of index-linked gilts stood at around £426bn at the end of 2018, according to the Debt Management Office, equivalent to roughly 26 per cent of the government’s overall debt portfolio. 

A DMO report from March 2019 showed that £21.3bn was issued in 2018-19, and £21.8bn was scheduled to be issued in 2019-20.

However, while this marked a nominal increase, the government plans to reduce index-linked gilts as a share of government bond issuance “in a measured fashion… over the medium term”.

Index switch
offered respite

As liabilities have climbed in recent years and trustee boards have grappled with funding deficits, some schemes have turned to their inflation measure as a way of reducing the cost of future pensions – in anticipation that RPI would become obsolete.

For some it has been an easy switch. Transport company Go-Ahead cut its liabilities by roughly £40m in April 2018 by changing its inflation measure to CPI, while food producer Dairy Crest reduced its funding deficit by £45m in 2017 with a similar change.

For others, however, the change has not been so straightforward. Scheme rules that are either too rigid or not properly worded can trip up trustees when they come to make a change to future benefits.

Children’s charity Barnardo’s was denied permission to move from RPI to CPI in November 2018 after a court battle, with the judge citing the “word order and grammatical construction” of lines in the scheme’s rulebook. BT Group had a similar experience in 2018 when it pushed for a change for members of its Section C DB scheme.

In April 2019, trustees of the Airways Pension Scheme – one of two DB plans sponsored by British Airways – reached an agreement with the employer to allow “discretionary” increases to keep benefits in line with RPI inflation, after another long-running legal battle.

“It’s not possible for schemes that are increasingly linking to CPI in terms of their liabilities to access matching assets”
Ian Neale, Aries Insight

Ian Neale, director at Aries Insight, adds: “Sponsoring employers want to take advantage of any opportunities to reduce costs, and switching to CPI linkage reduces their costs. [The problem] goes back to the days when the words ‘inflation’ and ‘retail price index’ were virtually synonymous. Scheme rules were often drafted in a less precise way than lawyers would choose nowadays.

“Most employers have lost and the courts have denied them the right to amend the rules to switch to CPI. There has been a lot of frustration.”

Alastair Meeks, partner at law firm Pinsent Masons, said following the announcement of the government’s consultation that there was “no agreement at all about what, if anything, should be done” regarding the scrapping of RPI.

“The courts have heard a string of cases from aggrieved employers who discovered 20 years after the fact that they had been playing roulette depending on which firm of pension lawyers’ boilerplate wording had crept into their trust deed and rules,” he told the law firm’s editorial service Out-Law. 

“Many have been stuck with RPI as a measure of inflation that no one regards as satisfactory and that has been downgraded from its former status as a national statistic, but which is still produced, and which their rules require them to use.”

Where are all the CPI gilts?

Try as they might, many DB pension schemes are stuck with RPI-linked benefits. With a deep and liquid market in inflation-linked bonds and swaps based on RPI, this has not been an issue. However, despite demand from investors, CPI-linked assets are few and far between.

With RPI having been stripped of its status as a national statistic in 2013, it has been a source of significant frustration for pension fund investors that the government has declined to issue significant amounts of CPI-linked debt, according to Mr Neale. 

“I find it difficult to understand – particularly given we’ve had eight years of CPI linkage,” Mr Neale says. “It’s a real handicap, because it’s not possible for schemes that are increasingly linking to CPI in terms of their liabilities to [access] matching assets. That is a big problem.”

The government also seems unwilling to significantly increase the size of the RPI market, with index-linked gilts set to reduce as a proportion of the nation’s overall sovereign debt issuance in 2019-20.

The current market for CPI-linked bonds – sovereign or corporate – is tiny compared with the RPI market, and any issuance usually gets snapped up by insurers, never to be seen again. 

The first CPI-linked bond was launched in 2015 by the Greater London Authority, which raised £200m through a 25-year bond to fund the development of the Northern Line. Cambridge University and BT Group issued CPI bonds in 2018, raising £300m and £1bn respectively through long-dated paper.

Heathrow Airport issued a dual RPI/CPI bond in 2018 in connection with a £325m pension fund derisking transaction with Legal & General. The bond was immediately bought by L&G, as it matched the liabilities it had just taken on through the derisking deal.

Rakesh Girdharlal, head of LDI at Aviva Investors, says the Debt Management Office – which is responsible for issuing government bonds – consulted on launching CPI-linked gilts but decided against it. “I think at the time they thought that, if they split the market and issued both CPI and RPI debt it would just result in a much less liquid market,” Mr Girdharlal says.

However, last year, deputy governor of the Bank of England Ben Broadbent told MPs there was no reason why the DMO could not issue CPI paper, arguing that there was enough depth and liquidity in the market to sustain both RPI and CPI bonds.

Unite opposes switch to CPIH

Unite, the UK’s biggest workers’ union, has been vocal in its opposition to the switch from RPI to CPIH. 

It contends that CPIH should not be used in negotiations related to workplace issues such as pensions, as it includes data from students, pensioners and tourists – groups “not relevant to the workers’ bargaining position”.

In September 2019, Unite general secretary Len McCluskey pledged to fight the change and proposed the union’s own inflation measure, the ‘Unite Bargaining Index’. “It is important that people understand what is at stake here,” McCluskey said.

“The RPI is not just a statistic. If we don’t fight this then millions of ordinary people will face cuts to their pay and pensions.”

He added that employers should not be able to “short-change” their staff and called for future negotiations to offer a choice between RPI and Unite’s index.

“The CPIH will not be an option for collective bargaining,” he said. 

Impact on
insurance market

Last year was a record year for pension risk transfers, with £17.6bn worth of buy-ins and buyouts completed in the first half of 2019 alone, and the full-year figure expected to easily pass £40bn. Some insurance companies are reporting full pipelines of business for 2020 already.

With the status of RPI-linked benefits uncertain, however, some derisking exercises may be delayed. For those considering a pension increase exchange, for example, it is currently very difficult for actuaries to assess whether swapping an inflation-linked annual increase for a one-off boost offers good value to scheme members.

In the insurance market there could be some good news, according to Barnett Waddingham’s Mr Mills. If RPI is lower, he explains, an RPI-linked scheme seeking an insurance deal could get a lower price. However, as schemes approach the point of transfer to an insurer, they will often have fully hedged their inflation risk – meaning the price may fall, but their assets will fall too.

“Historically, it has been relatively expensive to insure CPI-linked benefits because the insurers suffer from the same problem as everybody else: that CPI-linked assets are hard to find,” Mr Mills continues.

As a result, many insurance companies match CPI liabilities with RPI assets, which requires them to hold a capital buffer in accordance with Solvency II rules.

If the RPI methodology converges with that of CPI, Mr Mills says, the amount of additional capital insurers must hold could fall – and with it, the price of buy-ins and buyouts.

“For schemes with CPI-linked liabilities, they may have previously discounted [buy-ins and buyouts] as simply too expensive,” he adds.

“It may become a little more affordable for a few more of those schemes. It will take a little while to wash through as it’s about insurance companies changing their internal processes to reflect this change, which probably will not happen overnight.”

“Insurers suffer from the same problem as everybody else: CPI-linked assets are hard to find”
Ian Mills, Barnett Waddingham

The government has shown itself to be averse to rushing any changes to RPI, but the decision could be  out of its hands after 2030. 

In a letter to Sir David Norgrove, chair of the UK Statistics Authority, in September 2019, Mr Javid stated that, given the UK’s imminent exit from the EU, making such a substantial change to an important element of the country’s economy straight away would be inappropriate.

The chancellor recognised UKSA’s argument that RPI was “flawed” and “could be seen to undermine the integrity and credibility of the UK statistical system”. However, stopping its publication would “potentially be highly disruptive for the wide range of users of RPI”.

The chancellor continued: “Given the potential for significant and diverse effects of the change you have proposed, it must be appropriate to start from the assumption that some or all users in the public and private sectors, households, firms and financial markets will need substantial time to prepare.”

As such, Mr Javid has ruled out any changes being permitted before 2025. However, RPI-linked gilts maturing after 2030 do not require the chancellor’s input on changes to the inflation measure due to a change made to the bonds’ prospectuses – meaning the UKSA’s scrapping of RPI will definitely affect bonds with a maturity of more than 10 years from now.

“The announcement in September has definitely concentrated minds,” says Aries Insight’s Mr Neale. “It’s in the chancellor’s gift until 2030, but from then RPI – certainly as far as inflation measures are concerned – will be consigned to history.”

Yet more complication for GMPs

As if equalising guaranteed minimum pensions was not complicated enough, the RPI-CPI consultation threatens to add another layer of complication.

While GMPs accrued before April 5 1988 do not require inflation-linked uplifts, GMP benefits accrued from April 6 1988 to April 5 1997 must be increased by the lower of CPI or 3 per cent, according to law firm Hogan Lovells.

If CPI exceeds 3 per cent, members who reached state pension age before April 6 2016 receive a top up of the difference between 3 per cent and CPI, paid as an increase to their state pension.

While trustees and their advisers can make inflation estimates based on market expectations, it is harder to judge what the government will do with the RPI methodology at this stage.

Matt Davis, head of GMP equalisation at Hymans Robertson, has previously stated that schemes with inflation-linked benefits may have a lower GMP bill than those that do not.

Commenting last year on the impact of GMP on funding positions, Mr Davis said: “More generous schemes – those where members can get their full pension around age 60 with inflationary pension increases provided year on year on non-GMP pension – are likely to see a relatively low increase to pension liabilities due to GMP equalisation.” 

Future of inflation
protection

In light of the negative impact on asset owners and members, some are calling for a compensation package to ensure there are no losers from change.

Insight Investment has led this charge, taking out advertisements and producing a 16-page paper explaining the impact of the shift. It is calling for the government to add a 1 percentage point margin to the CPIH measure for existing RPI assets, to compensate those affected.

Mr Gall explains: “The argument really is to not create winners and losers after the change, so that everybody is in the same financial position as they were before. We appreciate that RPI has its flaws as a statistic, but they have been well-known for a long period of time. What we are looking to do is to fix that problem in an equitable way.

“If that were to come through, you would end up with RPI basically being very closely linked to CPI, plus that margin. And since that flows through on both sides of the equation for pension schemes in terms of both their assets and liabilities, it leaves them in the same financial position, and it leaves the pensioners in the same financial position.”*

“We appreciate that RPI has its flaws as a statistic, but they have been well-known for a long period of time”
Robert Gall, Insight Investment

Barnett Waddingham’s Mr Mills adds: “While the financial institutions affected will lobby powerfully to argue their case for compensation, I hope that we, the pensions industry, can come together to fight the corner of the people who matter most. This isn’t just about making sure the pension schemes are compensated – it’s about making sure the pensioners are.”

However, not everyone believes pensioners will lose out. Denying members inflation protection would be against the law, Mr Neale points out.

“When these scheme rules were drafted, RPI and inflation were regarded as the same thing,” he explains. “Now we have better measures, more accurate measures of inflation now available to us. If you are still being protected against inflation, I don’t see that the argument that you’re actually losing money stands up.

“Money is not being taken away from you; it’s not a cash sum that has been promised. Members have been promised protection against inflation and protection against inflation is what members will still have.”

For now, scheme trustees can only wait and see what the consultation brings. Mr Mills says those with directly held inflation-linked assets may want to ensure their voices are heard during the process, but the most important thing for all boards to consider is the structure and extent of their scheme’s inflation risk.

He adds: “Review inflation-related triggers, and for those with very high inflation hedge ratios it may be worth considering adjusting their inflation hedge ratio. While this would increase the scheme’s exposure to general inflation risk, it would also reduce the exposure to the gap between RPI and CPI – and could result in a lower overall risk level.”

*This article has been updated to correct a typographical error in a quote.*