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RIP RPI: your retirement income might be less than expected

The phasing out of the old way of measuring inflation could have a sizeable impact on your personal finances
 RIP RPI: your retirement income might be less than expected
  • RPI inflation measure will not be published from 2030
  • This means many inflation-linked products will grow by less

Protecting your portfolio from inflation is a key consideration in any financial plan. If you want to maintain the spending power of your money, you have to invest in assets other than cash as bank rates have been consistently lower than inflation over the last decade. While inflation has not been much of a concern in recent years, some fear that the unprecedented stimulus that has been pumped into economies could lead to an uptick in inflation as we emerge from the pandemic.

Unfortunately for some savers, Chancellor Rishi Sunak announced in late November that the Retail Price Index (RPI), a measure of inflation that many pension schemes and annuities link their returns to, will be phased out by 2030. This was not a surprise as former Bank of England govenor Mark Carney said in 2018 that RPI should be abandoned, and it has not been used as an ‘official’ statistic for many years. 

But it means that the income growth generated in a number of pension schemes and index-linked bonds could be significantly reduced when they are forced to link returns to the government's official inflation measure, the Consumer Prices and Housing Index (CPIH), from 2030.

 

<boxout>What is the difference between RPI and CPIH?

RPI, first calculated in 1947, was once the principal measure of inflation but the Office for National Statics has not classified it as a 'national statistic' since 2013. The ONS has continued to publish RPI, partly because a number of financial products link to it. The Consumer Price Index (CPI) became the government’s main measure of inflation following its inception in 1996. In November 2016 the CPIH replaced the CPI as the 'official' measure of inflation.

One significant difference between RPI and CPI was that CPI did not include housing, however CPIH was introduced in 2013 to include owner occupiers’ housing costs. Another difference is that the RPI excludes the top 4 per cent of households by income and pensioner households where three quarters or more of income comes from the state, unlike the consumer price indices. There are some other differences between them but the vast majority of the goods and services they include are common between them.

The key difference is in the way they are calculated. The RPI is an arithmetic mean, so the prices of all items included in it are added up and divided by the number of items. The CPI (and CPIH) is a geometric mean: it is calculated by multiplying the prices of all the items together and then taking the nth root of them, where 'n' is the number of items included.

An advantage for the government of using the geometric mean for liabilities is that, mathematically, the geometric mean is always lower than or equal to the arithmetic mean. This makes linking any payments the government makes to the CPIH (such as bonds and pensions) more affordable. Ben Lord, manager of M&G UK Inflation Linked Corporate Bond Fund (GB00B44JC482), says that the difference between RPI and CPIH, on average, is 0.8 per cent. 

Generally the change has been welcomed as the RPI is considered to at times greatly over and under estimate changes in prices, so is seen as a poor measure of inflation.

 

How annual CPIH and RPI rates have differed in recent years            
Year    RPI figure    CPIH figure    Difference
Oct-17    4.00%    2.80%    1.20%
Oct-18    3.30%    2.20%    1.10%
Oct-19    2.10%    1.50%    0.60%
Oct-20    1.30%    0.90%    0.40%
Source: ons.gov.uk/economy/inflationandpriceindices/datasets/consumerpriceinflation            

 

Impact on pension savers

The change mainly impacts defined benefit (DB) pensions schemes that have payments linked to RPI. The Pensions and Lifetime Savings Association estimates there are around 7.3m DB pension holders, which means a significant proportion of people will be impacted by this change. While government DB pension schemes have been linked to the CPIH for years, the Pension Policy Institute says 64 per cent of DB schemes have pension increases linked to RPI in their rules. When payments become linked to CPIH, the amount they increase by is likely to be considerably lower. 

As pension schemes are, by definition, a long-term product, just a small tweak in the methodology for increasing payments can have a huge impact on the value of the pension.

Gary Smith, financial planner at Tilney, says that over the last 10 years, the RPI has grown by 30 per cent while the CPI has grown by 21 per cent. “Using these figures as an example, if someone had retired 10 years ago, receiving an annual pension of £10,000, this would have increased to £13,034 using the RPI measure, whilst only increasing to £12,122 using the equivalent CPI measure, representing a fall in income of £912 per annum,” he explains. 

Due to the effect of compounding, the loss of income would be significantly greater over a 20 to 25-year retirement period, with potentially tens of thousands of pounds of income being lost. The Pension Policy Institute estimates that a man turning 65 today and receiving the average DB pension, is likely to receive £6,000 less over his lifetime, and a woman £8,000 less.

As it happens, most pension scheme members have different ‘tranches’ of benefits, according to Andrew Tully, technical director at Canada Life, which increase at different rates as a result of changing legislation. “Benefits built up recently are more likely to be linked to CPI rather than RPI. So the impact may be limited to only some of the member’s benefits,” Mr Tully points out.  

There is nothing that those affected can do about the inflation measure change, as the Chancellor announced that no compensation would be offered to those impacted. “The best way anyone can protect themselves from a shortfall is to see whether they can afford to put more away. This might be via additional voluntary pension contribution, or a stocks and shares ISA alongside the pension,” says Sarah Coles, personal finance analyst at Hargreaves Lansdown. The other option is to retire later.

David Gibb, a financial planner at Quilter, also notes that for those wishing to transfer to a defined contribution scheme, transfer values may fall in future as these are tied to the value of gilts. Fortunately the change doesn’t kick in until 2030 so anyone thinking about transferring out is likely to see their retirement income rise more slowly if their annuities are linked to RPI and they live beyond 2030.

Annuity holders are likely to see their retirement income rise more slowly if their annuities are linked to RPI and they live beyond 2030. While there are already CPI annuities, most are linked to RPI. “It’s going to be horrible news for anyone with this kind of annuity, because they weighed up the pros and cons of the product expecting higher inflation-linked rises, but will now automatically get something less rewarding,” says Ms Coles.

 

Impact on schemes

The funding of pension schemes may also be disadvantaged. Many schemes invest in index-linked Gilts, which increase in line with RPI and, when these change to CPI, the rates of return generated will fall, leaving a hole in schemes' funding, which will have to be addressed. The pension schemes will then be faced with difficult decisions in how to deal with this shortfall in funding. However, for schemes whose assets and liabilities are both RPI linked, the change may leave net funding broadly unaffected.  

Mr Tully says “the overall impact depends on how much of the scheme assets are invested in RPI-linked assets, how much of the benefits are linked to RPI and if they have any inflation-hedging in place. That’s difficult to tell scheme to scheme without significant research.”

 

Impact on bondholders 

Index-linked UK gilts are fairly common in portfolios particularly for risk averse investors. Mr Gibb points out that Mr Sunak’s announcement caused the prices of short- and medium-dated inflation-linked bonds to surge on the news that the change from RPI was going to be delayed until 2030 as these won’t be impacted, and many people expected the change to be made sooner.  

Ultimately, though, this shift in approach will lower the long-term returns from index-linked bonds held past 2030. So investors may want to factor that into their decision making should they wish to own long-term inflation protected bonds.

Ryan Hughes, head of active portfolios at AJ Bell, points out that away from dedicated inflation-protected bond funds, “index-linked bonds do not play a large part in most bond funds, with very low allocations in strategic bond funds. Therefore it is unlikely that many investors will see a material impact on their current portfolio.”

As already explained, it is those in DB schemes linked to RPI that will be most affected.  

 

Where personal finance benefits

A small number of taxes have price increases that are linked to RPI, so the move to CPI should - all other things being equal - mean their taxation increases by less than it would have otherwise. This applies to air passenger duty, tobacco and alcohol duty, and vehicle excise duty (better known as car tax). 

Mobile phone tariff price rises (the maximum rise allowed without triggering your right to leave the contract early) also fall under the changes as do regulated rail fare rises. And students should also be offered a small reprieve, as the interest on their loans should appreciate by less.