Following a period of consultation, the Government announced on 25th November 2020 its intention to align the Retail Price Index (RPI) with the Consumer Price Index including housing costs (CPIH) from 2030.
Historically, RPI and CPIH have averaged around 1% and 0.1% higher than CPI, respectively, so we can expect a substantial reduction in RPI from 2030 onwards.
The Government’s consultation response made clear that, although this change could have an adverse effect on the value of index-linked gilts, there will be no compensation paid to investors. Insight Investment has estimated that the RPI reform will effectively transfer around £100bn of value from index-linked gilt holders – primarily pension funds – to the government.
So, what does this mean for trustees? Here are some things to watch out for, and steps you can take to mitigate the risks.
1) Member benefits
In simple terms, the reform would mean a decline in the value of lifetime income for members versus using the old RPI methodology (although pensions are still uplifted in both cases). According to the Pensions Policy Institute, members in schemes with RPI-linked increases will be around 9% worse off over their lifetimes. This has led to trustees of BT, Ford, and Marks and Spencer seeking a judicial review of the final decision of RPI reform consultation. Watch this space for developments.
2) Scheme funding positions
Although this will differ from scheme to scheme, the impact will depend on the extent to which pension liabilities are linked to either RPI or CPI (or both) as well as the type, extent, and shape of inflation hedges used.
The consensus among scheme advisors is that the impact on RPI-linked liabilities is not expected to be material for most schemes’ funding positions since the change in the liabilities and their corresponding RPI-linked hedges would theoretically be in line. Where some or all liabilities are not hedged, the expected reduction in liabilities could actually improve the funding position, but this depends on the market-implied yields which have so far not significantly changed to reflect the reform. The impact on your scheme will also depend on any mismatch and shape of any hedging employed versus the liabilities as pointed out by XPS Pensions Group. For now this is something to keep in mind to discuss with your advisors and actuaries.
Given the scarcity of CPI-linked assets, most actuarial assumptions use the market-implied RPI curve minus a fixed spread, known as CPI-RPI “wedge”, usually around 1% to derive a best-estimate CPI curve. The consensus amongst the top advisors is that this will change to 1% for pre-2030 liabilities and 0%-0.1% for post-2030 liabilities. More importantly, this has to be set by the scheme actuaries and trustees and updated in the scheme CPI assumptions.
As noted by LCP, given the index-linked gilt market implied RPI curve was broadly unchanged post the RPI-reform announcement, most such schemes would see their post-2030 liabilities effectively increase!
Therefore, such schemes could suffer a funding deterioration through the increase of their CPI-linked liabilities, and also through the reduction of the RPI-linked assets used for hedging (to the extent they have hedged). LCP estimates that such CPI-linked liabilities could increase by up to 10% in some schemes. The government’s own response to this potentially large impact was that the number of DB schemes with CPI-linked liabilities is small, with around a third of total DB scheme benefits linked to CPI.
3) Sponsor covenant
Since scheme liabilities may potentially increase and/or hedging assets decrease in value, resulting in a deterioration of funding position, this could ultimately lead to a need for higher contributions from the sponsor to cover the shortfall. This could add extra pressure to some sponsors with weak covenants.
4) Member options
Any increases in CPI-linked liabilities could affect member options, such as transfer values (CETVs). They could also increase by 10% or more and therefore trustees need to revisit the terms of such options and discuss appropriate actions with their actuaries.
What should trustees be doing to prepare for this change?
Here are some considerations for trustees now and on an ongoing basis to mitigate potential risks to their schemes due to the RPI reform:
1) Check scheme rules again to identify and review the affected member benefits arising from this reform.
2) Revisit your funding assumptions with your actuary as soon as possible. Make sure they are fit for purpose and pay special attention to any CPI assumptions; this is especially urgent if there are valuations that are currently underway.
3) Where schemes are hedged, discuss the impact of the RPI reform on the scheme size and shape of the hedges with your advisers. This will help avoid unpleasant surprises.
4) If your scheme has pre-existing trigger points for hedging, any changes could inadvertently trigger one. So revisiting funding assumptions is even more crucial in this situation.
5) For schemes already in deficit, the length and nature of the recovery plan or the extent of recovery contributions may need to be updated and agreed with the sponsoring employer. Trustees will need to revisit their funding and investment plans and possibly update the scheme SFP and SIP.
6) CETVs may increase due to assumed CPI increase – review your transfer value assumptions.
7) If a scheme is considering buy-in or buy-out, the underlying assumptions, as well as any potential pricing changes, may need re-consideration.
8) Effective member communication is crucial to make sure members do not misunderstand the impact of the RPI reform on their benefits.
Going forward, one thing is for sure, there will not be any lack of controversy surrounding this topic as many schemes come to terms with its wide-reaching consequences.
This blog first appeared on Pension Funds Insider.