Pensions hit by move from RPI to CPI

2nd December 2011

Today there has been a court ruling which covers the switch of inflation indices for public-sector occupational pensions. It is an area about which I feel strongly for the reasons explained below.

Two main groups of people will find their futures adversely affected by the change from the Retail Price Index to the Consumer Price Index as the inflation measure used in indexing both pensions and benefits. These are pensioners in public-sector occupational schemes (more commonly called final salary schemes) and those receiving state benefits. So this change was one of the factors leading to the public-sector pensions strike on Wednesday. Due to the way that there can be "creep" from such moves we may see some private-sector occupational pensions be affected too.

This is one of those factors which operates in the background but in fact is likely to prove to be very expensive over time.


Why is this so?

In general the Retail Price Index rises at a faster rate than the Consumer Price Index. This is for several reasons but the main two are that the RPI is constructed differently in terms of mathematics and that it does not use what are called hedonics to reduce the inflation rate. It is also true that the RPI has some measure of housing inflation whereas the CPI does not.


What does this mean in practice?

If we look at annual inflation from 2002 to 2009 we see the differences.

CPI: 1.3%;1.4%;1.3%;2.1%;2.3%;2.3%;3.6%;2.2%


Even the 2009 number is in fact not really a gain for the CPI as the reverse effect will apply when interest-rates and mortgage rates eventually rise again.


Why does this matter to a pensioner?

Imagine you retire at 65, you might reasonably expect these days to live to 90. So your pension has to support you for 25 years. Now imagine that it falls short of inflation by 1% a year. You would be more than 25% worse off and if we allow for compounding around 28%.

So if you retired on £10,000 a year you might be £2,800 worse off in the last year in real or inflation adjusted terms in addition and you will have built up a sequence of losses over the period of your pension. So something which at first seems minor now looks significant and in fact expensive and will build up year after year so that the total losses will be considerable. It will also have its greatest effect when you are least likely to be in a position to do anything about it.

The same principle holds whenever this change of indexation is made. So some benefits claimants will suffer from this problem and in future tax bands will be indexed to CPI too.


It appears likely to get worse as official bodies change their view

I have been relatively rare among economists in that I have criticised this move from the beginning as a stealth reduction of benefits. I believe that public-sector pensions do need reform but that the reform should be transparent and not via stealth measures. Also I am one of those who feels that we may be seeing a widening of the gap between the two measures. So that past records (which are bad enough) do not represent the likely worse future.

This week the Office for Budget Responsibility joined me. From their working paper of the 29th of November and the emphasis is mine.

"Between 1989 and 2011 Retail Prices Index (RPI) inflation tended to be around 0.7 percentage points higher than Consumer Prices Index (CPI) inflation on average. Recent developments suggest that the long-run difference between these measures may be significantly higher in the future."

Pensioners, benefit claimants and taxpayers may already be wondering how much this "significantly higher" gap will cost them. The OBR  now estimates that going forwards it is likely to cost 1.4% per annum. So there is their estimate of the cost of the move and for all of the governments excuses the real reason for doing it. They save money at the expense of pensioners, benefit claimants and as time goes by taxpayers. That doesn't leave many out!

If we analyse those most likely to be affected adversely by the move it will be some of the poorest members of our society. So not only is this move a type of stealth taxation it is also likely to be regressive which in my view makes it a bad policy.


More from Mindful Money:

What measure should we be using for inflation?

Public sector pension strikes: Big society investing

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