Out with the envelopes, in with Alexa

Bloomberg calls it the “The World's Dullest Multibillion-Dollar Scandal”.  The House of Lords toned it down to “index shopping”. The Independent deemed it “failure to get pesky ‘strappy top’ prices right”.  However you describe it, there is no denying that the RPI vs CPI debate is back on the agenda. 

A tale of two indices

For those unfamiliar with the two leading measures of UK price inflation, the RPI is the old stalwart that has rather been left behind in the era of “big-data”, and CPI is the “new kid on the block”, albeit very well established at this stage as the Government’s primary economic inflation measure.  The House of Lords issued a damning report earlier this year recommending that RPI is corrected, and quickly in respect of the ‘strappy top’ issue.  Further, they suggested that the Government shouldn’t ‘index shop’ – using RPI for things they didn’t care about getting bigger (eg student loan interest) and CPI for things they wanted to keep under control (eg state benefits) - and that there should be a programme of convergence towards a single measure of inflation over time. 

Markets responded to the House of Lords report with, broadly, a 0.2% drop in expected RPI (implying that investors expect RPI to be slightly lower in future, though other factors may also have been at play in the current volatile market conditions).  Life insurers have so far taken little action and, generally, are yet to make any changes to their pricing assumptions for buy-ins and buy-outs of pension schemes pending further evidence that a change to RPI is likely.

A response is expected in April from officials in the ONS and the Treasury department.

So what should trustees consider?

Most pension schemes will have a combination of CPI and RPI linked benefits, and inflation-linked assets, so the starting point should be to understand how any changes would apply to your scheme.  The two key areas to consider are the potential impact on the scheme assets – most notably those linked to or hedging inflation – and the impact on the scheme’s liabilities – essentially increases to benefits both before and after they come into payment.

On the asset side, you should look at your current inflation hedges.

Whether you will “win” or “lose” depends on the extent of your asset hedging and whether that hedging is linked to RPI.  Many pension schemes have a high degree of hedging, almost all linked to RPI; therefore, if the formula for RPI changes so that RPI reduces and moves closer towards CPI there will be a significant loss on those hedges (indeed, for some it could be huge: of the order of 10% or more of the aggregate value of the scheme’s assets in extreme cases).  Can your scheme afford to take the risk; are there other ways to achieve this hedging?

On the liability side, what are the benefits paid by the Scheme?

If the RPI formula moves to be aligned to CPI, there will be lower benefits paid to members with RPI-linked benefits. However, importantly, at the scheme level, in some cases the reduction in the liabilities may be much less than the cost on the asset side, as liabilities linked to CPI will be unaffected.  

What opportunities might exist going forward?

Uncertainty also creates opportunities, and for schemes considering strategic moves in the near future, there may be some tactical positions that can be taken.  For example:

• Try to avoid hedging CPI benefits using RPI instruments – We have seen some investment sub-committees pausing hedging programmes in the current market (where further hedging was planned based on RPI on the asset side, to match CPI on the liability side). Of course, this has to be weighed against the risk of being under hedged against inflation generally, or the cost of proper CPI hedges.
• “Cheap” insurer pricing for CPI benefits – Insurer quotes are currently still based on a similar assumed difference between RPI and CPI as before, even though expected RPI has (probably) reduced a little. This may mean that insurers are effectively selling CPI protection at better value than previously. Schemes with predominately CPI benefits who are considering a buy-in or buy-out may find it is worth striking a price sooner rather than later.
• A time-limited “bargaining chip” – We estimate that around a quarter of trustees already have the flexibility in their Scheme rules to choose CPI as the index for pension increases, but very few have chosen to do so. Most scheme sponsors would be keen to make such a change as soon as possible, even if RPI might start to look like CPI in future anyway. CPI is widely recognised as a better statistical measure of inflation and so arguably more closely aligned to the original purpose of pension increases anyway, although members and unions may not quite see it that way.  Some trustees might be looking for something from their sponsors (eg support for a risk transfer to an insurer, additional contributions, or further covenant support) and may find that now is a good time to consider “cashing in” this flexibility in exchange for something that could be of greater value in the long term.  This will need to be weighed up very carefully with the impact of lowering some members’ benefit expectations, even if this is only in the shorter term.

The only thing that is certain is uncertainty

There will always be change in inflation indices, and the removal of envelopes from the basket – in favour of adding digital assistants – is part of that natural evolution.  The rate of inflation could throw us a surprise too: in the ‘60s few expected the double digit inflation of the ‘70s and ‘80s.  Add Brexit to the mix, and inflation could continue to surprise us – making it vital to prepare for all possibilities, while keeping an eye out for any opportunities to improve your long-term position.     

* The views expressed in this blog are those of the authors and not necessarily those of the firm.