Firstly thank you to those who sent me good wishes for my holiday. Lake Como is a lovely part of the world but was extremely hot even for an Englishmen whose climate has this year given him something of an acclimatisation programme. As I did play some golf I did my best to live up to Noel Coward’s lyric only “Mad dogs and Englishmen go out in the midday sun”, however to be fair to them mad dogs were noticeable by their absence! During my time away I notice that the mood in financial markets has become noticeably more optimistic with equity markets undergoing strong rallies with the American S&P 500 index up by more than 3% on Wednesday. One factor which has caught my eye is the fact that the Bank of England maintained its official interest rate at 0.5% for the 16th month and the European Central Bank kept its equivalent at 1% for the 14th month. If you think about it such moves (as in lack of them) is perhaps something of an indictment of the state of economic recovery prospects in Europe and the UK. If you look back to previous recoveries from output setbacks of the size we had in 2008/9 they have usually been much stronger than what we have now. A small increase in the IMF’s forecast for world growth simply does not cut it when looked at in that way and interestingly included a trimming of its UK forecasts.
Changes in the UK inflation index
I wrote an article on this subject on the day of the UK Emergency Budget as I feel very strongly about this issue. I did not realise that I was going to be proved prescient quite this quickly however.
Furthermore there is another corollary to this. These moves tend to spread so that anybody who has a private sector pension that depends on a promised benefit level rather than a fund value is likely to be affected as time goes by from a type of inflation index creep.
Yesterday the Pensions Minister Steve Webb announced plans to extend the (new) use of the Consumer Prices Index to legislation surrounding personal defined benefit pensions in the UK.
“We believe, therefore, it is right to use the same index in determining increases for all occupational pensions and payments made by the Pension Protection Fund and Financial Assistance Scheme.”
In some ways the lowest blow is the impact of the changes on the Pension Protection Fund which helps those who are members of defined benefit schemes which have become insolvent. For the protection they receive was relatively limited anyway. To properly discuss this area I intend to explain the differences between the indices and the implications for the members of such schemes.
The Differences between the Consumer Price Inflation index and the Retail Price Index
The beginning of the CPI as a method of inflation measurement came from the European Union where it was originally called the Harmonised Index of Consumer Prices (HICP). This index was developed to assess whether prospective members of European Monetary Union would pass the required inflation convergence criterion and then of acting as the measure of inflation used by the European Central Bank to assess price stability in the euro area. So its introduction as CPI in the UK was a type of convergence with the European Union.
However,there are significant differences between the CPI and the RPI. The CPI excludes a number of items that are included in RPI-X the previous target inflation measure and these mainly relate to housing and housing costs. These differences include council tax and a range of owner-occupier housing costs such as mortgage interest payments, house depreciation, buildings insurance, as well as estate agents and conveyancing fees. It also excludes Trade union subscriptions and vehicle excise duty. Conversely the things included in CPI but not in RPIX are of more minor influence ( Unit trust and stockbroker fees, University accommodation fees, Foreign students tuition fees and foreign exchange commission for purchases of sterling by overseas visitors).
The two indices cover different population bases as the base for the RPI and its variants excludes the highest income households and pensioners who depend on state benefits. Whereas CPI covers all households including foreign visitors to the UK. There are also some specific price measurement differences for example with second-hand cars.
The last major difference is that individual prices are combined in the two indices in different ways according to different formulae in each expenditure category.The CPI uses the geometric mean, which allows for the substitution of cheaper goods for more expensive goods when relative prices change. The RPI and its variants use arithmetic means which do not allow for substitution.
How much does this matter?
The original documentation for the change was produced in the period of late 2003 and it has an interesting statement on this subject.
Since January 1989, RPIX inflation has exceeded CPI inflation by an average of 0.7 percentage points and, at 1.3 percentage points in October 2003, the difference is currently quite wide.
One might think that such a time “currently quite wide” might be not the time to make such a change but the then Chancellor did not have such doubts. I demonstrated the differences since 2002 in the two inflation indices in my article on Budget Day (22nd June) but today I have added RPIX to the comparison as it excludes mortgage costs. This is because some suggest that for pensioner households this is not appropriate. The annual rates of change from 2002 are.
The differences are plain to see where CPI is consistently lower and if we aggregate my numbers with those from the original research they have been consistently so since at least 1989. If you are not persuaded by these numbers then perhaps a statement by a government agency(its own savings body) may help as on the National Savings website one can find.
The RPI includes housing costs and council tax, and is calculated in a different way, so it tends to be higher than the CPI. NS&I has always used the RPI to calculate increases in the value of Index-linked Savings Certificates, and we continue to do so.
There is a clear implication that it is a better index in that statement.
The impact of this on private sector defined benefit pensions
This is a complicated area and I will try to explain it as simply as possible.There are two main types of pension in the private sector. One which is called defined contribution where you build up a fund value is unaffected by these changes although there may be future implications. The other type is where the member of a scheme is promised a level of benefits in the future hence the name defined benefits and these are also called final salary pensions as the pension relates to ones “final salary”. These will be affected.
The impact comes as follows. The government sets legislation which provides for minimum annual increases when a pension is being paid. These matter because with rising life expectancy pensioners these days can reasonably expect to live for around 20/30 years. Over this period even a low rate of inflation will eat substantially into their pension. The current minimum level of inflation protection is called limited price inflation where benefits accrued before the 6/4/2005 rise at the RPI capped at 5% per annum and those accrued after this date saw the rise capped at 2.5% per annum. Please go back to the figures I have quoted above to see the impact of this as I believe example figures help.
There is a group who are likely to be affected more severely and it is those who leave such a scheme early and they are called early leavers or deferred pensioners. Their benefits are protected by legislation which gives them a minimum level of inflation protection. This is to cover the gap between them leaving their employer and the retirement age to help protect them against the impact of inflation. For them benefits accrued before 6/04/09 are protected by LPI of up to 5% and benefits accrued after this date are protected by LPI of up to 2.5%. So for them a change in the rules has a double whammy effect as the period up to retirement will then be followed by the effect in the previous paragraph. So the joint impact could be somewhat severe in real terms.
I have deliberately excluded some elements in my explanation above as there are differences in the treatment of benefits when they relate to private pension schemes covering what are in effect government set benefits such as a Guaranteed Minimum Pension. They add enormously to the complexity and add little to the explanation so I have glossed over them to try to help readers eyes from glazing over…
There are some clear implications from my analysis.
1. This change in inflation index is a retrograde step which will affect many pensioners in the future as it is being extended from public sector to private sector schemes.
2. It could in the end affect others as the government already intends to extend the use of CPI to such matters as the indexation of tax allowances. This move is even more inappropriate than the move for pensions.
3. Pension legislation during the last government did in effect break the unwritten rule in the UK that governments do not act retrospectively. This government is now continuing and adding to this trend. This is very serious as it brings into question the nature of long-term contracts and this must lead to individuals wondering if pension saving is worthwhile. Changing the rules always leads to fears that they are being changed unfavourably and undermines the credibility of any contract or guarantee. In this instance the change is clearly unfavourable.
Now one needs to be careful with words here as I have seen a lot of misguided writing on this subject as the indices which the government is changing set minimum levels for private sector pensions so it is not forcing them to change as they have the option of exceeding them. However as these schemes in general have large deficits they are increasingly likely to offer only the minimum level of inflation protection. Should this happen then as I have suggested above if you believe RPI will in general exceed CPI, then this change means that this government is effectively proposing to allow pension schemes to reduce the value of members’ accrued benefits and not just future ones. This has very serious implications, as such changes have never been permitted before.
In my articles we have looked at may issues including the nature of wealth and money. Now we come to the value and credibility of long-term contracts. It is not a one way street as in the past governments have had good intentions when proposing legislation for these schemes as the minimum level of inflation protection was well intended. However this new move is going in the other direction and if we find ourselves doing a version of the “hokey-cokey” I hope that questions will be asked about the affordability of some of the changes that have been made in the past. Our political elite finds it easy these days to escape the implications of their actions…
For those who hold index-linked government bonds (gilts)
If you look at the original documentation for the introduction of CPI as an inflation index you first see an interesting statement.
Pensions benefits and index-linked gilts continue to be calculated on exactly the same basis as in the past with reference to the all-items Retail Prices Index RPI or its derivatives.
So we are now seeing what is an example of inflation index creep some 7 or 8 years later and I would suspect that holders of index-linked gilts will now be reading their contracts. Anybody who has an index-linked annuity will probably be wise to do the same.