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RPI VS. CPI
MAGIC NEW FORMULA WILL LEAD TO SHRINKING WEDGE
OCTOBER 2012
www.redington.co.uk/www.pensioncorporation.com 1
Executive Summary
Background
The difference between RPI and CPI as inflation measures has been a statistical nuisance to
understand and explain for the UK government for some time.
The difference stems from two factors:
1) Composition; CPI excludes housing and council tax
This has historically accounted for the larger part of the difference though the
effect can be in either direction.
2) Formula Effect
This has accounted for a smaller part of the difference, but the effect consistently
biases RPI above CPI. The effect increased in January 2010 to around 100bps,
driven largely by changes to the methodology in the measurement of clothing
and footwear 1
.
.
The Consumer Prices Advisory Committee (CPAC), whose role is to advise the UK
Statistical Authority (UKSA) on the measurement of inflation, has initiated a managing the
formula effect (MFE) programme to “identify, understand and remove unjustified causes of
the formula effect gap”. This is important as approximately 75-100bps of the “wedge”
between CPI and RPI is derived from the difference in the formula chosen to assess and
collect data.
In light of their findings, the CPAC are in consultation to reduce and potentially eliminate the
gap through data stratification and/or changing the current RPI methodology. Four
options are being assessed ranging from “do nothing” to “full alignment between RPI and
CPI”. Expected from 2013, it is anticipated that there will be some convergence with the
effect of reducing the RPI. General market expectation is a long term fall in RPI of around
50-75bps. The 15-year RPI expectation implied by index-linked gilts market has fallen to
around 2.35% p.a which is 70bps below its peak from its peak in April this year and about
50bps below the position on 18 May 2012 when the consultation was announced.
Possible impact
Any moves to narrow the RPI/CPI wedge could impact:
 Issuers of index-linked bonds – both Government and private sector
 Buyers who may start pricing in a “political risk” of further future changes to
calculation methodologies.
 Holders of the £177billion of index-linked gilts (“linkers”) in issuance
1
ONS – CPI and RPI: increased impact of the formula effect in 2010
www.redington.co.uk/www.pensioncorporation.com 2
 RPI swaps participants
 Pension schemes with RPI liabilities
 Pensioners with RPI-linked benefits
Key considerations for pension schemes
This possible change, like the previous move to change statutory indexation from RPI to
CPI, highlights the need for pension schemes to fully understand the financial implications of
inflation on their liabilities and to hedge them.
Lower inflation and expectations of future inflation will, other things being equal, lead to a
decrease in scheme liabilities. To the extent that schemes have hedged their exposure to
inflation, they will of course neither participate in the positive effects of falling inflation or the
negative effects of rising inflation.
The Redington/PIC survey published in 2011 highlighted that on average, UK pension
schemes had hedged only 25% of their inflation exposure. This leaves them significantly
exposed to moves in inflation.
Recent Developments
 Latest September CPAC minutes announced a consultation commencing 8 October
2012 to invite users’ views on the options for the way RPI is calculated. The options
presented were:
1. No change
2. Change approach to averaging prices for some categories
3. Change approach to averaging prices for all categories that use the
CARLI or arithmetic averaging approach (see section 1 for more
details)
4. Change RPI so formulae fully align with CPI
 The consultation is expected to run to the end of November 2012 at which point, the
CPAC will reconvene to consider the responses including any recommendations by
the National Statistician.
 Market pricing is likely to build in changes when they become likely, ahead of actual
implementation.
 Recent fall in market implied inflation (20-25bps) between April 2012 and 1 October
2012 could be attributed in part to expectations of CPAC action.
www.redington.co.uk/www.pensioncorporation.com 3
Next Steps
 If changes were to be proposed, these would be introduced with the annual update of
the RPI when it is published on 19 March 2013.
 Although the Chancellor of the Exchequer must gives its final approval to any
proposed changes to RPI methodology should the Bank of England find them
“materially detrimental to the interests of the holders” of index-linked gilts, this is not
an insurmountable condition to getting the RPI to narrow towards CPI.
 It is unclear whether there has been any precedent for what constitutes “materially
detrimental” in such circumstances. However, changing RPI and by implication
lowering it towards CPI would potentially bring into opposition the interests of linker
holders and HM Treasury. Assuming the CPI target is not revised higher to
compensate the loss of the formula effect wedge, then all other things being equal,
the future value of RPI cashflows (and hence linkers, and breakeven inflation swaps)
should fall.
www.redington.co.uk/www.pensioncorporation.com 4
Table of Contents
1. BACKGROUND .............................................................................................................. 5
2. THE ONS, CLOTHING AND WEDGES.......................................................................... 7
3. ENTER CPAC ................................................................................................................. 8
4. CONCLUSION .............................................................................................................. 11
www.redington.co.uk/www.pensioncorporation.com 5
1. Background
History of CPI vs. RPI2
Fundamental differences between the Consumer Price Index (CPI) and Retail Price Index
(RPI) as measures of inflation can be outlined as follows:
1. Composition Effect – Housing costs and council tax are not included in CPI,
whereas it is included within RPI.
2. Formula Effect - CPI uses a geometric mean of relative prices whereas RPI uses
either an arithmetic mean of relative prices OR a ratio of average prices between
months.
The key point is that the differential or “wedge” between the CPI and RPI has meant that for
a 2% CPI target in steady state, you can expect a higher RPI level of c.100bps3
. This is
partly a mathematical effect. The gap in individual years is volatile and can be materially
higher or lower than 100bps. Indeed, CPI has exceeded RPI in several individual years. But
averaged over the long term RPI (if methodology is unchanged) is very likely to exceed CPI.
The Formula Effect
The first few steps of the calculation of inflation between two periods involve the collection of
a number of price quotes in both periods from retailers or suppliers. These quotes are then
in some way averaged and a relative change established from one period to the next.
There are several mathematical approaches to the averaging and ratio calculation, which are
used both within the RPI and CPI methologies in addition to standard weighted averaging :
 CARLI – Average of price relatives
Takes the ratio of a matched pair of prices in both periods and takes the
arithmetic average of all ratios in a well defined group of products
 JEVONS – Ratio of average prices
Geometric mean of price ratios or ratio of geometric mean prices
 DUTOT – Ratio of average prices
Takes an arithmetic average in both periods, of all prices in a well defined
group of products and takes the ratio of those averages
Source: ONS user engagement July 2012
2
Please refer to section 3 of our December 2011 paper - “UK Final Salary Pension Schemes: Inflation Hedging
and the change in Indexation from RPI to CPI survey results”, which discusses these differences and their
contribution to CPI/RPI basis risk in more detail.
3
ONS: Economic and fiscal outlook March 2011.
www.redington.co.uk/www.pensioncorporation.com 6
The application of the different methodologies as a proportion of the RPI and CPI is
compared below:
CPI RPI
30% JEVONS 25% CARLI
30% DUTOT 30% DUTOT
40% Weighted average 45% Weighted average
Source: ONS user engagement July 2012
The formula effect arises due to the difference in the JEVONS and CARLI methodologies
used within 25-30% of each index. A large part of the methodologies behind each index are
in fact the same.
Other countries around the world, particularly the EU, use methodologies similar to the
JEVONS.
www.redington.co.uk/www.pensioncorporation.com 7
2. The ONS, Clothing and Wedges
Back in 2010, the Office for National Statistics (ONS) changed the methodology for
collecting clothing prices. They applied a less stringent standard to allowing items to enter
the clothing basket by allowing price comparisons to be included where there had been a
small change to the characteristics of a piece of clothing from one month to the next. The
reasoning behind this being - fashions change, so why only include items that are stuck on
the rails from last month? In addition, seasonal items were also included (boots, beachwear
etc) rather than only items that were likely to be featuring in the basket throughout the year.
Sale items were also included in the price quotes.
The impact of the 2010 changes in including changing fashions and seasonal items was to
make the basket of goods more variable month on month and that variability broadly
translates into a larger CPI vs. RPI wedge. This is because, while the RPI and CPI have the
same clothing basket, increased variability accentuated the formula gap by increasing the
dispersion of the price relatives. In monetary terms, the 2010 changes were seen by some
investment banks as causing the move in size of the formula effect from approximately
50bps since 2009, to 100bps in 2011 of RPI over CPI4
. At the time, the changes were
intended as a way of drawing more items into the “basket” to create a more representative
sample for RPI/CPI calculations.
4
Morgan Stanley – February 2012: A New RPI-CPI Wedge?
www.redington.co.uk/www.pensioncorporation.com 8
3. Enter CPAC
The Consumer Prices Advisory Committee (CPAC) began investigating the formula effect
in May 2011. This became a programme of managing the formula effect (MFE) with the
purpose to “identify, understand and remove unjustified causes of the formula effect gap
between the CPI and RPI”5
.
The minutes of the July 2012 CPAC meeting noted that the CPAC are making progress with
the MFE programme. Any recommendations from the CPAC to change the UK inflation
measures in light of their findings could have implications for several areas if such
recommendations are then adopted by the ONS and approved by the Bank of England
(BOE) and UK Government.
Minutes Release – Impact on Gilt Breakeven Inflation
Figure 1: 15-Year Gilt Breakeven Inflation (as at 2 October 2012)
Source: Bloomberg, Redington
In the two weeks following the release of the CPAC minutes on 18 May, 15-year breakeven
inflation dropped by more than 25bps in anticipation of a narrowing gap between the RPI
and CPI. Though the downward trend continues, other factors have also weighed on the
decline of breakeven rates such as the renewal of BoE quantitative easing programme and
recent sharp falls in oil prices. US and European markets have also seen sliding inflation
from respective policy interventions interacting with economic outlook.
5
CPAC Papers – April 2012 meeting: Progress Update on Managing the Formula Effect
2.3
2.4
2.5
2.6
2.7
2.8
2.9
3.0
3.1
%
18 May 2012: CPAC
minutes released
18 Sep 2012: CPAC
minutes released
www.redington.co.uk/www.pensioncorporation.com 9
What can you “improve” if you want to have a smaller formula effect?
Stratification
One way of managing down the price variability is to stratify the data. For instance, by
differentiating between supermarkets, departments stores, discount outlets, online etc rather
than simply by “independent” and “multiple” retail outlets as is currently the case.
Unfortunately, stratification by itself only removes a small part of the formula effect.
Formula
The second way of reducing the formula effect is to change the methodology. For example,
by calculating RPI using the geometric rather than the arithmetic average.
Out of the September CPAC meeting, a consultation document is to be published on 8
October 2012 to invite users’ views on a range of options, ranging from no change to a full
alignment of the RPI formulae to CPI6
.
It is important to note that there is more than one change being proposed here. Firstly
stratification and secondly changing the actual calculation for RPI from an arithmetic mean to
geometric mean. Although both will have the impact of reducing the formula effect, the
compositional impact remains from housing prices in RPI. This had been anticipated by the
CPAC and in June 2012, the ONS announced a consultation on the inclusion of housing
costs in CPI7
.
Hurdles to RPI changes
There are hurdles to simply changing RPI methodologies, not least the impact on the UK
index-linked gilts market. The formal process differs for some traditional 8-month lag linkers
versus the newer 3-month lag linkers, however, in summary the parties involved in the
decision process are the UK Statistical Authority, the Bank of England and, ultimately, the
Chancellor of the Exchequer.
Bondholder Protection
The Statistics and Registration Service Act which covers changes to RPI provides some
protection to bondholders. Investors holding the traditional 8-month index-linked gilts will be
able to redeem their bonds. However, it seems they would only receive the accrued index
ratio to date. In the current low yield environment, redeeming these bonds which, in most
cases, had been issued with a coupon higher than current rates, would mean the investor
will receive a price less than the actual market value of the bond.
6
ONS – CPAC September 2012 Meeting Summary Note
7
ONS: Consultation on the recommended method of reflection owner occupiers’ housing costs in a new
additional measure of consumer price inflation, and the strategy for Consumer Price statistics
www.redington.co.uk/www.pensioncorporation.com 10
However, the protection for the 3-month linker holders is less than that of the 8-month linkers
and in summary, there is nothing in the documents that prevents a change to the index.
Nevertheless, before making any changes to the RPI, the UKSA must “consult the BOE as
to whether the change constitutes a fundamental change in the index which would be
materially detrimental to the interests of the holders” of index-linked gilts. If the BOE does
consider the changes to be materially detrimental then the UKSA may not make the changes
without approval from the Chancellor of the Exchequer.
It is unclear whether there has been any precedent for what constitutes “materially
detrimental” in such circumstances. However, changing RPI and by implication lowering it
towards CPI would potentially bring into opposition the interests of linker holders and HM
Treasury. Assuming the CPI target is not revised higher to compensate the loss of the
formula effect wedge, then all other things being equal, the future value of RPI cashflows
(and hence linkers, and breakeven inflation swaps) should fall.
www.redington.co.uk/www.pensioncorporation.com 11
4. Conclusion
Where does it lead?
The face value of the UK linker market stands at £177bn8
and given the potential cost and/or
need for compensating bond holders, one would think that much will depend on approval
and consultation. However, given the level of access of the CPAC to the Bank of England
and HM Treasury to discuss the issue, this gives the impression this process is being taken
seriously and that legislation has a chance of passing.
If the CPAC is successful in achieving its mandate of “identifying and eliminating unjustified
differences” between CPI and RPI, the formula effect will effectively be eliminated, and a
major precedent will have been set.
Key considerations for Pensions
At a fundamental level, the indices are alternative measures which is why we have two
rather than one inflation index. Without getting into the argument here of which is a better
representation of the cost of living for retirement benefits, the likely effects of eliminating
“unjustified” differences from the formula effect are:
 The convergence of the RPI and CPI index, most likely in the direction of RPI
decreases rather than CPI rises
 Market expectations of moves in inflation will continue to be priced and reflected
within the respective bonds and swaps markets
 While liabilities remain indexed against the RPI, index-linked gilts and RPI swaps will
continue to function as liability matching instruments.
Although the extent and timing of the changes are liable to remain uncertain in the coming
months, the narrowing of the RPI to CPI wedge highlights the reality that general inflation
risk poses a much greater risk to most schemes than the basis risk between the two. The
industry revisits a question raised by the previous move to change statutory indexation from
RPI to CPI; are trustees / sponsors truly aware of the overall financial implications of inflation
on their pension scheme liabilities?
Lower actual inflation as well as expectations of future inflation will, other things being equal,
lead to a decrease in scheme liabilities. To the extent that schemes have hedged their
exposure to inflation, they will neither participate in the positive effects of falling inflation or
the negative effects of rising inflation.
At first thought, there may be an inclination to wait in the idea that inflation hedging will be
cheaper in the near future, given the anticipated fall in the relative index. However, markets
also react to information and there is evidence that inflation markets (e.g. Index-linked gilts,
8
DMO – June 2012: Index-linked gilts in issue.
www.redington.co.uk/www.pensioncorporation.com 12
swaps) have already begun to price in the possible changes. Attempting to call the inflation
market is therefore no easier now than it was before.
The Redington/PIC survey published in 2011 highlighted that on average, UK pension
schemes had hedged only 25% of their inflation exposure. Irrespective of the outcome of the
current consultation, this leaves them significantly exposed to moves in inflation.
The priority of these schemes should be to increase overall levels of inflation protection.
There is a risk that the current uncertainty over the RPI calculation method will lead to
inaction in the hope of cheaper hedging opportunities in the future. Instead, schemes should
recognise that inflation is one of their largest unhedged risks. As demonstrated by the break-
even charts, hedging instruments such as index-linked gilts and inflation swaps have already
allowed for the expected/possible change in RPI calculation methodology.
A more significant problem posed may be the limited supply of hedging instruments
available on the market. Currently, versus a total pensions liability of c.£7 trillion9
, the UK
only has £335 billion of inflation-linked gilts, c.£30 billion of UK corporate index-linked bonds
(e.g. utility companies), and a further estimated £100 billion in the inflation swap market.
9
ONS, A fuller picture of the UK’s funded and unfunded pension obligations, April 2012
www.redington.co.uk/www.pensioncorporation.com 13
Disclaimer
© Redington Limited and Pension Corporation LLP 2012. All rights reserved. No
reproduction, copy, transmission or translation of this publication may be made without
Redington and Pension Corporation’s status as the authors being acknowledged .

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RPI VS. CPI - Magic New Formula will Lead to Shrinking Wedge

  • 1. RPI VS. CPI MAGIC NEW FORMULA WILL LEAD TO SHRINKING WEDGE OCTOBER 2012
  • 2. www.redington.co.uk/www.pensioncorporation.com 1 Executive Summary Background The difference between RPI and CPI as inflation measures has been a statistical nuisance to understand and explain for the UK government for some time. The difference stems from two factors: 1) Composition; CPI excludes housing and council tax This has historically accounted for the larger part of the difference though the effect can be in either direction. 2) Formula Effect This has accounted for a smaller part of the difference, but the effect consistently biases RPI above CPI. The effect increased in January 2010 to around 100bps, driven largely by changes to the methodology in the measurement of clothing and footwear 1 . . The Consumer Prices Advisory Committee (CPAC), whose role is to advise the UK Statistical Authority (UKSA) on the measurement of inflation, has initiated a managing the formula effect (MFE) programme to “identify, understand and remove unjustified causes of the formula effect gap”. This is important as approximately 75-100bps of the “wedge” between CPI and RPI is derived from the difference in the formula chosen to assess and collect data. In light of their findings, the CPAC are in consultation to reduce and potentially eliminate the gap through data stratification and/or changing the current RPI methodology. Four options are being assessed ranging from “do nothing” to “full alignment between RPI and CPI”. Expected from 2013, it is anticipated that there will be some convergence with the effect of reducing the RPI. General market expectation is a long term fall in RPI of around 50-75bps. The 15-year RPI expectation implied by index-linked gilts market has fallen to around 2.35% p.a which is 70bps below its peak from its peak in April this year and about 50bps below the position on 18 May 2012 when the consultation was announced. Possible impact Any moves to narrow the RPI/CPI wedge could impact:  Issuers of index-linked bonds – both Government and private sector  Buyers who may start pricing in a “political risk” of further future changes to calculation methodologies.  Holders of the £177billion of index-linked gilts (“linkers”) in issuance 1 ONS – CPI and RPI: increased impact of the formula effect in 2010
  • 3. www.redington.co.uk/www.pensioncorporation.com 2  RPI swaps participants  Pension schemes with RPI liabilities  Pensioners with RPI-linked benefits Key considerations for pension schemes This possible change, like the previous move to change statutory indexation from RPI to CPI, highlights the need for pension schemes to fully understand the financial implications of inflation on their liabilities and to hedge them. Lower inflation and expectations of future inflation will, other things being equal, lead to a decrease in scheme liabilities. To the extent that schemes have hedged their exposure to inflation, they will of course neither participate in the positive effects of falling inflation or the negative effects of rising inflation. The Redington/PIC survey published in 2011 highlighted that on average, UK pension schemes had hedged only 25% of their inflation exposure. This leaves them significantly exposed to moves in inflation. Recent Developments  Latest September CPAC minutes announced a consultation commencing 8 October 2012 to invite users’ views on the options for the way RPI is calculated. The options presented were: 1. No change 2. Change approach to averaging prices for some categories 3. Change approach to averaging prices for all categories that use the CARLI or arithmetic averaging approach (see section 1 for more details) 4. Change RPI so formulae fully align with CPI  The consultation is expected to run to the end of November 2012 at which point, the CPAC will reconvene to consider the responses including any recommendations by the National Statistician.  Market pricing is likely to build in changes when they become likely, ahead of actual implementation.  Recent fall in market implied inflation (20-25bps) between April 2012 and 1 October 2012 could be attributed in part to expectations of CPAC action.
  • 4. www.redington.co.uk/www.pensioncorporation.com 3 Next Steps  If changes were to be proposed, these would be introduced with the annual update of the RPI when it is published on 19 March 2013.  Although the Chancellor of the Exchequer must gives its final approval to any proposed changes to RPI methodology should the Bank of England find them “materially detrimental to the interests of the holders” of index-linked gilts, this is not an insurmountable condition to getting the RPI to narrow towards CPI.  It is unclear whether there has been any precedent for what constitutes “materially detrimental” in such circumstances. However, changing RPI and by implication lowering it towards CPI would potentially bring into opposition the interests of linker holders and HM Treasury. Assuming the CPI target is not revised higher to compensate the loss of the formula effect wedge, then all other things being equal, the future value of RPI cashflows (and hence linkers, and breakeven inflation swaps) should fall.
  • 5. www.redington.co.uk/www.pensioncorporation.com 4 Table of Contents 1. BACKGROUND .............................................................................................................. 5 2. THE ONS, CLOTHING AND WEDGES.......................................................................... 7 3. ENTER CPAC ................................................................................................................. 8 4. CONCLUSION .............................................................................................................. 11
  • 6. www.redington.co.uk/www.pensioncorporation.com 5 1. Background History of CPI vs. RPI2 Fundamental differences between the Consumer Price Index (CPI) and Retail Price Index (RPI) as measures of inflation can be outlined as follows: 1. Composition Effect – Housing costs and council tax are not included in CPI, whereas it is included within RPI. 2. Formula Effect - CPI uses a geometric mean of relative prices whereas RPI uses either an arithmetic mean of relative prices OR a ratio of average prices between months. The key point is that the differential or “wedge” between the CPI and RPI has meant that for a 2% CPI target in steady state, you can expect a higher RPI level of c.100bps3 . This is partly a mathematical effect. The gap in individual years is volatile and can be materially higher or lower than 100bps. Indeed, CPI has exceeded RPI in several individual years. But averaged over the long term RPI (if methodology is unchanged) is very likely to exceed CPI. The Formula Effect The first few steps of the calculation of inflation between two periods involve the collection of a number of price quotes in both periods from retailers or suppliers. These quotes are then in some way averaged and a relative change established from one period to the next. There are several mathematical approaches to the averaging and ratio calculation, which are used both within the RPI and CPI methologies in addition to standard weighted averaging :  CARLI – Average of price relatives Takes the ratio of a matched pair of prices in both periods and takes the arithmetic average of all ratios in a well defined group of products  JEVONS – Ratio of average prices Geometric mean of price ratios or ratio of geometric mean prices  DUTOT – Ratio of average prices Takes an arithmetic average in both periods, of all prices in a well defined group of products and takes the ratio of those averages Source: ONS user engagement July 2012 2 Please refer to section 3 of our December 2011 paper - “UK Final Salary Pension Schemes: Inflation Hedging and the change in Indexation from RPI to CPI survey results”, which discusses these differences and their contribution to CPI/RPI basis risk in more detail. 3 ONS: Economic and fiscal outlook March 2011.
  • 7. www.redington.co.uk/www.pensioncorporation.com 6 The application of the different methodologies as a proportion of the RPI and CPI is compared below: CPI RPI 30% JEVONS 25% CARLI 30% DUTOT 30% DUTOT 40% Weighted average 45% Weighted average Source: ONS user engagement July 2012 The formula effect arises due to the difference in the JEVONS and CARLI methodologies used within 25-30% of each index. A large part of the methodologies behind each index are in fact the same. Other countries around the world, particularly the EU, use methodologies similar to the JEVONS.
  • 8. www.redington.co.uk/www.pensioncorporation.com 7 2. The ONS, Clothing and Wedges Back in 2010, the Office for National Statistics (ONS) changed the methodology for collecting clothing prices. They applied a less stringent standard to allowing items to enter the clothing basket by allowing price comparisons to be included where there had been a small change to the characteristics of a piece of clothing from one month to the next. The reasoning behind this being - fashions change, so why only include items that are stuck on the rails from last month? In addition, seasonal items were also included (boots, beachwear etc) rather than only items that were likely to be featuring in the basket throughout the year. Sale items were also included in the price quotes. The impact of the 2010 changes in including changing fashions and seasonal items was to make the basket of goods more variable month on month and that variability broadly translates into a larger CPI vs. RPI wedge. This is because, while the RPI and CPI have the same clothing basket, increased variability accentuated the formula gap by increasing the dispersion of the price relatives. In monetary terms, the 2010 changes were seen by some investment banks as causing the move in size of the formula effect from approximately 50bps since 2009, to 100bps in 2011 of RPI over CPI4 . At the time, the changes were intended as a way of drawing more items into the “basket” to create a more representative sample for RPI/CPI calculations. 4 Morgan Stanley – February 2012: A New RPI-CPI Wedge?
  • 9. www.redington.co.uk/www.pensioncorporation.com 8 3. Enter CPAC The Consumer Prices Advisory Committee (CPAC) began investigating the formula effect in May 2011. This became a programme of managing the formula effect (MFE) with the purpose to “identify, understand and remove unjustified causes of the formula effect gap between the CPI and RPI”5 . The minutes of the July 2012 CPAC meeting noted that the CPAC are making progress with the MFE programme. Any recommendations from the CPAC to change the UK inflation measures in light of their findings could have implications for several areas if such recommendations are then adopted by the ONS and approved by the Bank of England (BOE) and UK Government. Minutes Release – Impact on Gilt Breakeven Inflation Figure 1: 15-Year Gilt Breakeven Inflation (as at 2 October 2012) Source: Bloomberg, Redington In the two weeks following the release of the CPAC minutes on 18 May, 15-year breakeven inflation dropped by more than 25bps in anticipation of a narrowing gap between the RPI and CPI. Though the downward trend continues, other factors have also weighed on the decline of breakeven rates such as the renewal of BoE quantitative easing programme and recent sharp falls in oil prices. US and European markets have also seen sliding inflation from respective policy interventions interacting with economic outlook. 5 CPAC Papers – April 2012 meeting: Progress Update on Managing the Formula Effect 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3.0 3.1 % 18 May 2012: CPAC minutes released 18 Sep 2012: CPAC minutes released
  • 10. www.redington.co.uk/www.pensioncorporation.com 9 What can you “improve” if you want to have a smaller formula effect? Stratification One way of managing down the price variability is to stratify the data. For instance, by differentiating between supermarkets, departments stores, discount outlets, online etc rather than simply by “independent” and “multiple” retail outlets as is currently the case. Unfortunately, stratification by itself only removes a small part of the formula effect. Formula The second way of reducing the formula effect is to change the methodology. For example, by calculating RPI using the geometric rather than the arithmetic average. Out of the September CPAC meeting, a consultation document is to be published on 8 October 2012 to invite users’ views on a range of options, ranging from no change to a full alignment of the RPI formulae to CPI6 . It is important to note that there is more than one change being proposed here. Firstly stratification and secondly changing the actual calculation for RPI from an arithmetic mean to geometric mean. Although both will have the impact of reducing the formula effect, the compositional impact remains from housing prices in RPI. This had been anticipated by the CPAC and in June 2012, the ONS announced a consultation on the inclusion of housing costs in CPI7 . Hurdles to RPI changes There are hurdles to simply changing RPI methodologies, not least the impact on the UK index-linked gilts market. The formal process differs for some traditional 8-month lag linkers versus the newer 3-month lag linkers, however, in summary the parties involved in the decision process are the UK Statistical Authority, the Bank of England and, ultimately, the Chancellor of the Exchequer. Bondholder Protection The Statistics and Registration Service Act which covers changes to RPI provides some protection to bondholders. Investors holding the traditional 8-month index-linked gilts will be able to redeem their bonds. However, it seems they would only receive the accrued index ratio to date. In the current low yield environment, redeeming these bonds which, in most cases, had been issued with a coupon higher than current rates, would mean the investor will receive a price less than the actual market value of the bond. 6 ONS – CPAC September 2012 Meeting Summary Note 7 ONS: Consultation on the recommended method of reflection owner occupiers’ housing costs in a new additional measure of consumer price inflation, and the strategy for Consumer Price statistics
  • 11. www.redington.co.uk/www.pensioncorporation.com 10 However, the protection for the 3-month linker holders is less than that of the 8-month linkers and in summary, there is nothing in the documents that prevents a change to the index. Nevertheless, before making any changes to the RPI, the UKSA must “consult the BOE as to whether the change constitutes a fundamental change in the index which would be materially detrimental to the interests of the holders” of index-linked gilts. If the BOE does consider the changes to be materially detrimental then the UKSA may not make the changes without approval from the Chancellor of the Exchequer. It is unclear whether there has been any precedent for what constitutes “materially detrimental” in such circumstances. However, changing RPI and by implication lowering it towards CPI would potentially bring into opposition the interests of linker holders and HM Treasury. Assuming the CPI target is not revised higher to compensate the loss of the formula effect wedge, then all other things being equal, the future value of RPI cashflows (and hence linkers, and breakeven inflation swaps) should fall.
  • 12. www.redington.co.uk/www.pensioncorporation.com 11 4. Conclusion Where does it lead? The face value of the UK linker market stands at £177bn8 and given the potential cost and/or need for compensating bond holders, one would think that much will depend on approval and consultation. However, given the level of access of the CPAC to the Bank of England and HM Treasury to discuss the issue, this gives the impression this process is being taken seriously and that legislation has a chance of passing. If the CPAC is successful in achieving its mandate of “identifying and eliminating unjustified differences” between CPI and RPI, the formula effect will effectively be eliminated, and a major precedent will have been set. Key considerations for Pensions At a fundamental level, the indices are alternative measures which is why we have two rather than one inflation index. Without getting into the argument here of which is a better representation of the cost of living for retirement benefits, the likely effects of eliminating “unjustified” differences from the formula effect are:  The convergence of the RPI and CPI index, most likely in the direction of RPI decreases rather than CPI rises  Market expectations of moves in inflation will continue to be priced and reflected within the respective bonds and swaps markets  While liabilities remain indexed against the RPI, index-linked gilts and RPI swaps will continue to function as liability matching instruments. Although the extent and timing of the changes are liable to remain uncertain in the coming months, the narrowing of the RPI to CPI wedge highlights the reality that general inflation risk poses a much greater risk to most schemes than the basis risk between the two. The industry revisits a question raised by the previous move to change statutory indexation from RPI to CPI; are trustees / sponsors truly aware of the overall financial implications of inflation on their pension scheme liabilities? Lower actual inflation as well as expectations of future inflation will, other things being equal, lead to a decrease in scheme liabilities. To the extent that schemes have hedged their exposure to inflation, they will neither participate in the positive effects of falling inflation or the negative effects of rising inflation. At first thought, there may be an inclination to wait in the idea that inflation hedging will be cheaper in the near future, given the anticipated fall in the relative index. However, markets also react to information and there is evidence that inflation markets (e.g. Index-linked gilts, 8 DMO – June 2012: Index-linked gilts in issue.
  • 13. www.redington.co.uk/www.pensioncorporation.com 12 swaps) have already begun to price in the possible changes. Attempting to call the inflation market is therefore no easier now than it was before. The Redington/PIC survey published in 2011 highlighted that on average, UK pension schemes had hedged only 25% of their inflation exposure. Irrespective of the outcome of the current consultation, this leaves them significantly exposed to moves in inflation. The priority of these schemes should be to increase overall levels of inflation protection. There is a risk that the current uncertainty over the RPI calculation method will lead to inaction in the hope of cheaper hedging opportunities in the future. Instead, schemes should recognise that inflation is one of their largest unhedged risks. As demonstrated by the break- even charts, hedging instruments such as index-linked gilts and inflation swaps have already allowed for the expected/possible change in RPI calculation methodology. A more significant problem posed may be the limited supply of hedging instruments available on the market. Currently, versus a total pensions liability of c.£7 trillion9 , the UK only has £335 billion of inflation-linked gilts, c.£30 billion of UK corporate index-linked bonds (e.g. utility companies), and a further estimated £100 billion in the inflation swap market. 9 ONS, A fuller picture of the UK’s funded and unfunded pension obligations, April 2012
  • 14. www.redington.co.uk/www.pensioncorporation.com 13 Disclaimer © Redington Limited and Pension Corporation LLP 2012. All rights reserved. No reproduction, copy, transmission or translation of this publication may be made without Redington and Pension Corporation’s status as the authors being acknowledged .