Consultation on the Reform to Retail Prices Index Methodology – Sackers’ response to consultation

Background

The UK Statistics Authority (“UKSA”) and HMT are jointly consulting on reforming the methodology of the Retail Prices Index (“RPI”).  RPI has been held to have shortcomings, and the UKSA has recommended changes to it, proposing that the calculation methodology should be aligned with the Consumer Prices Index including owner occupiers’ housing costs (“CPIH”).

In certain circumstances, changes to RPI require the consent of the Chancellor of the Exchequer before they can be implemented (this requirement expires in 2030). The Chancellor’s decision on consent may only consider factors related to the government’s issues of index-linked gilts.

The consultation seeks responses on the UKSA’s proposed approach to changing the methodology of RPI. The Chancellor also seeks responses on the potential impact of the proposals on the holders of index-linked gilts (and on the index-linked gilt market), and whether the UKSA’s proposal should be made for a date other than 2030 and, if so, when between 2025 and 2030.

In this response

• General comments
• Responses to specific questions

General comments

We welcome the opportunity to comment on the proposals, and to relay to the UKSA and Government some of the concerns expressed by our clients as to potentially significant consequences of the proposals.

We have not sought to answer every question in the consultation but have limited our responses to those areas which are pertinent to our practice.

Responses to specific questions

2. What will be the impact on the interests of holders of ‘relevant’ index-linked gilts (i.e. 2½% IL 2020, 2½% IL 2024 and 4 1/8% IL 2030) of addressing the shortcomings of the RPI in a) 2025 b) 2030 or c) any year in between?
3. What will be the impact on the interests of holders of all other index-linked gilts of addressing the shortcomings of the RPI in a) 2025 b) 2030 or c) any year in between?

Our comments are relevant to both questions 2 and 3.

The impact of the proposed alignment of RPI with CPIH will vary between schemes, depending on how and the extent to which they have hedged their inflation risk.

Holders we represent and the gilts they hold

• Where gilts expire beyond the date of the proposed change (whatever date this may occur), the return will obviously be impacted, with the impact felt increasing the longer the expiry date.
• As noted in the consultation paper, defined benefit pension schemes are likely to hold gilts to hedge their inflation-linked liabilities. There is substantial demand from defined benefit pension funds seeking to hedge inflation-linked liabilities (linked to RPI, limited price inflation or CPI), and from other investors seeking to match other indexed liabilities. Therefore, this change holds potentially serious consequences for pension schemes.
• Defined benefit exposures go beyond 2030. We are aware of clients holding index-linked gilts that mature much later, and would expect that very many schemes hold gilts with dates well beyond the 2030 longstop for the changes (as noted in the consultation document, the longest-dated outstanding index-linked gilt extends to 2068). Defined benefit liabilities are long-term, and therefore schemes typically buy long-term instruments to match those liabilities.

Distinction between ‘relevant’ holders and other holders

• While the holders of relevant gilts (the last of which issue in 2030) will be more likely to enjoy the statutory protection (ie that changes cannot be made without consent until then), this may not have been fully understood at the time of purchase. We note that the terms of gilts other than relevant gilts refer to any decision to replace RPI being made by Chancellor of the Exchequer after consultation with a body of independent experts with recognised expertise in the construction of price indices.
• Our response does not otherwise seek to distinguish between holders of different types of gilts.

Impact on funding position for schemes with Consumer Prices Index (“CPI”) and Limited Price Indexation (“LPI”) linked liabilities

• Schemes holding RPI-linked gilts to hedge CPI-linked liabilities (which is common, as currently there is very little available by way of hedging CPI directly), or those which move in line with LPI, will feel a significant impact, with falls in funding levels a knock-on effect. (They will also have paid for the gilts they hold on the assumption that they will provide income based on RPI calculated using the current methodology (see below)).
• As a result, it may take such schemes significantly longer periods to achieve their goals (for example, de-risking). In terms of broader impact, part of that cost will be borne by the economy.
• The financial impact of the ‘wedge’ between RPI and CPIH has an impact on longer holders, whatever method is chosen – whether a change to the methodology or the index.

Impact on holders generally, including those with RPI liabilities

The funding position of schemes with full hedges (ie with RPI liabilities precisely matched with RPI instruments) might be assumed not to be adversely affected, as the alignment proposed in the consultation should result in an equal reduction in both assets and liabilities. However, holders may still experience a negative impact on funding levels depending on their funding position.

All schemes are likely to feel they have ‘overpaid’ for their hedging, which will deliver smaller returns (1% being the average difference between RPI and CPIH since 2010) than anticipated.

Please see our response to Question 6 for additional points.

5. What other impacts might the proposed changes to address the shortcomings of the RPI have in areas or contracts where the RPI is used?

• A change in index has an effect both on the value and efficiency of the hedge held (particularly if the benefits hedged do not move precisely in line with RPI e.g. because they are linked to limited price inflation or CPI). Hedging portfolios that have been carefully designed would become less accurate in light of the anticipated change, and require reworking. Pension schemes that have hedged responsibly, reasonably (on the basis of a particular expectation about the reference index) and as recommended by TPR, for example, will feel that they are being unfairly penalised for having done so.
• Other scheme assets which provide returns based on RPI, including long-term infrastructure debt or property portfolio investments, and inflation-linked bonds issued by entities other than government, will also provide lower returns once the proposed alignment takes effect, reducing the current value of those assets.
• Member benefits / pensioner income: the impact of the proposed alignment of RPI with CPIH will depend on how the scheme’s rules on increases (in deferment and/or payment) are expressed. As noted above, RPI has historically been higher than CPIH (by around 1% a year over the last decade). If there is no mitigation offered in relation to the changes, many pensioners will receive lower benefits than they would have expected to, with older members and those already in receipt of their pension having limited time to adapt to such changes.
• Transfer values: schemes with a high proportion of RPI-linked benefits could be overstating cash equivalent transfer values (“CETVs”)^[1] under existing methodologies.
• The proposed alignment of RPI with CPIH could have an impact on the buyout and bulk annuity market, and providers may find it harder to price inflation-linked liabilities. Past buyouts and bulk annuities will have been priced using assumptions including those relating to rates of inflation. Similarly, insurers will have hedged their liabilities with gilts (in whole or part). Going forwards, annuity payments will be linked to inflation as stated, whether or not providers have hedged this.
• The change may also be relevant to Pension Increase Exchange (“PIE”) options (under which scheme members exchange their non-statutory increases for a higher flat-rate pension, where inflation assumptions are key in determining the uplifts to members’ pensions (and will be crystallised at a particular point in time), and commutations.
• It is worth noting that sponsoring employers’ covenants are also likely to affected by the changes (e.g. if the employer has RPI-linked income), with knock-on effects for scheme funding and investment strategy. Any negative impact on funding has an impact on security of benefits and on employers’ funding obligations.

6. Are there any other issues relevant to the proposal the Authority is minded to make of which the Authority or the Chancellor ought to be aware?

• We would note that many clients and those in the industry, whilst recognising the nuances of the issue, feel strongly about the implications of the proposals. As pension schemes bought gilts on the expectation of income based on the current RPI methodology, it is felt by some that there is a strong case for compensation or for the future income stream to be based on CPIH plus a spread.
• We would ask that any changes are not implemented before 2030, to give schemes as long as possible to plan for them and to mitigate the negative effects. As discussed above, the alignment will have material negative impacts for many and the earlier the change, the more disruptive it will be.