RPI pathways: Plotting the way ahead for pension funds
With the public consultation into the potential phasing out of the retail price index (RPI) as an inflation measure in the UK having closed in August, we take a look back over the history of the debate on RPI reform and consider the three most likely outcomes to help pension funds plan for the road ahead
A short history of RPI reform
The RPI’s many shortcomings have been well documented for many years and are largely undisputed. Suffice to say that misgivings over the accuracy of the RPI resulted in its replacement by the consumer price index (CPI) as the Bank of England’s inflation target as far back as 2003. The Office for National Statistics (ONS) has not classified the RPI as a “national statistic” since 2013, as it is no longer deemed to meet international standards.
More recently, parliamentary enquiries and independent reviews have led to the government adopting a version of the CPI adapted to include housing costs (known as the CPIH) as its lead inflation statistic. However, given that the RPI has long been embedded as the inflation measure in government and private sector contracts, attempts to replace or discontinue the index altogether have proved highly controversial.
Rolling 12-month UK inflation 31 December 2003 – 31 July 2020
Having originally decided to continue calculating the RPI as a legacy index despite the flaws with the index’s methodology, in March 2019 the ONS recommended phasing out the RPI altogether and aligning all inflation adjustments with the CPIH as an interim measure. Although the government’s public consultation into the ONS’s proposal has now ended, it is unclear when an announcement on the way forward will come – it may well be that we have to wait until the next Budget, which is expected in the Spring of 2021, before the fiscal year-end.
Assessing the pricing impact on index-linked Gilts
The uncertainty over the future of RPI is particularly unsettling for pension funds. Not only is the RPI written into many defined benefit trust deeds as the reference index for benefit adjustments, but the index is also used to adjust the coupon and principal payments on index-linked Gilts. By our estimate, pension funds hold around two thirds of the total index-linked market and so many funds stand to lose out financially if the RPI is aligned to the CPIH without compensation being offered to affected bondholders.
To assess the potential exposure of pension funds, we’ve looked at the extent to which RPI reform has already been priced into index-linked Gilts. Liquidity in the inflation market is relatively thin, especially in the CPI space, but by looking across some key indicators (the forward swaps wedge and the inversion of the RPI forward curve), we estimate that full alignment to the CPIH is about 60%-80% priced in at the time of writing.
Three potential outcomes
Given the potential for further price disruption in the index-linked Gilt market, we think pension funds should prepare for three potential scenarios: no alignment of the RPI with the CPIH; full alignment with the CPIH excluding compensation for index-linked Gilt holders; and alignment with the CPIH including compensation for index-linked Gilt holders.
For each scenario, we’ve assessed the rationale that would drive the decision and the expected impact on index-linked Gilts.
Potential RPI-Reform scenarios
No alignment with CPIH would produce the most positive result for holders of index-linked Gilts. It remains possible that the can gets kicked down the road yet again, especially given the wider economic circumstances that have unfolded as a result of the Covid-19 pandemic. RPI reform would also have a particularly adverse impact on the Conservative Party’s older voter base. Whether the Chancellor feels this is the best time to push through such a contentious reform remains to be seen. The price impact on index-linked Gilts would be expected to be positive, with the market regaining around 12%-15% of its value, or around £50 billion – £68 billion from current prices.
However, the government may take the opportunity to align the RPI fully with the CPIH. Given the absence of any mention of compensation in the consultation paper, the possibility that an alignment could take place without compensating holders of affected index-linked Gilts remains on the table. In this scenario, index-linked bond prices would be expected to lose around 4%-6% of their value, which is equivalent to overall losses of around £15 billion - £30 billion for the market as a whole.
To avoid disruption, the RPI could also be aligned with the CPIH while smoothing the path for those index-linked bondholders affected by the decision. Compensation could be achieved by adding a fixed margin above the CPIH for the purpose of indexing affected inflation-linked securities. Assuming that the margin is set at a reasonable level, around 50 basis points (bps) above the CPIH, we would expect linkers to rise approximately 2%-5% from present levels, amounting to a rise in value of around £7 billion - £24 billion for the market as a whole.
Introducing our Index-Linked Gilt Pricing Dashboard
We’ve plotted each RPI reform scenario on our Index-Linked Gilt Pricing Dashboard. We do not expect major changes in the RPI reform debate, but we expect to update our analysis periodically to reflect changes in the market backdrop, including when key milestones are reached.
Index-linked gilt pricing dashboard
What our analysis does clearly show is the wide dispersion in potential outcomes, depending on how the government decides to move forward.
We believe that, on balance, the Chancellor is most likely to opt to push ahead with RPI reform now rather than delay further. We also think it’s most likely that compensation will be provided for holders of affected index-linked Gilts via a fixed margin of around 50bps above the CPIH for indexing purposes.
Choosing to align the RPI with the CPIH in this way would, in our view, be the cleanest way of addressing the statistical concerns raised by the RPI, while avoiding value transfers by delivering compensation in an equitable manner across current and future holders of linkers.