The reform of RPI
Following the conclusion of the recent consultation on the reform of the Retail Prices Index (“RPI”, “the Consultation”), it is likely that from the year 2030, RPI will be aligned with CPI-H (Consumer Prices Index including Housing costs). This means that the actuarial assumptions used to calculate CPI-linked liabilities for UK pension schemes are likely to change for future actuarial valuations, resulting in a step-change in liability values and therefore a potential mismatch with the corresponding liability hedge.
For schemes with a material proportion of post-2030 CPI-linked benefits, the impact is expected to be large, and it may be appropriate to take action to rebalance the liability hedge now rather than waiting for the next actuarial valuation. Please see below for more details.
In September 2019, the Chancellor released some recommendations from the UK Statistics Authority regarding the use of RPI as one of the primary measures of inflation in the UK. The announcement recommended that the publication of RPI should cease and that the calculation of RPI be brought in line with the calculation for CPI-H.
A consultation was subsequently published to determine when the change should happen between 2025 and 2030, and what technical approach should be taken. A large number of respondents also offered a view on whether compensation should be given to holders of Index-Linked bonds.
The Consultation was concluded at the end of November 2020 and the main outcomes were:
- The government will not be bringing forward the reform date, meaning the RPI calculation will likely be changed from 2030
- It is likely RPI will be aligned with CPI-H
- The government doesn’t plan to provide any compensation to holders of RPI-linked assets.
The full response to the Consultation can be found HERE.
Market impact on RPI expectations
As can be seen from the above graph, long-dated RPI inflation expectations have gradually trended downwards over the last two years. CPI-H increases have historically been lower than RPI increases so our view is that at least some of this can be interpreted as the market pricing in the expectation of the RPI calculation methodology changing to be in line with CPI-H.
This meant that when the expected outcomes of the Consultation were announced at the end of November 2020, the outcomes were largely already “priced in” and long-dated inflation expectations did not move significantly (in fact they actually rose marginally).
Recently the impact from the announcement alone is slightly lost among other big drivers of market movements we saw last year such as COVID-19 and Brexit.
The main issue for schemes to be concerned with going forwards is the change in actuarial assumptions as a result of this announcement.
Many UK pension schemes have benefits linked to CPI. As the market for CPI-linked instruments is very illiquid and therefore the future rate of CPI increases is difficult to determine, actuaries generally value CPI-linked benefits by assuming future CPI will be some fixed deduction below future RPI (for example setting CPI = RPI - 1% p.a.).
We generally refer to this deduction as the “wedge” assumption.
The long term historic average of this wedge is c. 0.75% - 1.0% p.a.. This has been gradually falling over the last couple of years and, since the conclusion of the Consultation, has fallen to within the c. 0% - 0.2% range as shown on the graph overleaf. We have shown this below at the 30 year term as an example, but other terms post-2030 also show a wedge in this range.
When RPI is moved to be calculated in line with CPI-H (likely in 2030), the historic wedge between RPI and CPI will greatly reduce (or disappear). This means that as pension schemes go through their triennial valuation process over the coming years, the actuarial assumption for the wedge will likely be reduced too. Although liability values may have fallen slightly due to the falls in long- dated RPI following the recommendation in 2019, the reduction in the RPI-CPI wedge assumption will cause the following (all else being equal):
- A step-change in liability values (these are most likely to increase as the size of the wedge is reduced). The level of the step change depends on the level of CPI linked liabilities that your scheme
- As the liability value increases, the interest rate and inflation risk in your liabilities are also likely to change which will impact your hedging levels
- The scheme’s liability hedge could therefore be inaccurate until it is amended following your next actuarial valuation.
The size of the impact on your scheme will depend upon a variety of factors; for example what proportion of benefits are linked to post-2030 CPI and what the size of the current wedge assumption is. For most schemes the impact is likely to be low (or too small to warrant the costs of taking action).
However, depending on the benefit structure of your scheme, should the post-2030 CPI exposure be a significant portion of your liabilities the impact could be large. In this scenario, action should be taken to rebalance the liability hedge sooner rather than later. If this is the case for your scheme you should discuss with your investment consultant the possibility of amending your liability hedge to reflect up-to-date information, with input from the Scheme Actuary, in advance of your next valuation.
River and Mercantile Solutions is a division of River and Mercantile Investments Limited, which is authorised and regulated in the United Kingdom by the Financial Conduct Authority (Firm Reference No. 195028; registered in England and Wales No.3359127) and is a subsidiary of River and Mercantile Group PLC (registered in England and Wales No. 04035248), with its registered office at 30 Coleman Street, London EC2R 5AL.
Please note that all material produced by River and Mercantile Solutions is directed at, and intended for, the consideration of professional clients only within the meaning of the Financial Services and Markets Act 2000. Retail clients must not place any reliance upon the contents.
Please note that this article is not a statement of the law and is intended for general information purposes only. It does not constitute legal or investment advice and we are not responsible for any result arising from reliance on its content. Specific advice should be taken if you think any of the matters referred to affect you – please contact us if we can help.
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