Inflation tweaks could cost savers and investors £122bn

The myriad challenges of the here and now mean you’re probably not that worried about a bit of technical fiddling over the way inflation will be measured when calculating government bond pay outs in 2025. Or possibly 2030.

But perhaps you should be, because it could end up costing savers and investors as much as £122bn.

On Friday, the consultation over when and how the discredited Retail Prices Index (RPI) should be abolished in favour of the Consumer Prices Index including housing costs (CPIH), quietly closed.

You won’t find many people who think RPI is a great way of working out how prices change.

Losing its gold status as a national statistic back in 2013, the measure has an unnerving tendency of both under- and over-estimating inflationary changes. The way the measure is calculated also means it doesn’t always accurately reflect who experiences those changes or how.

Over time, the majority of products, services and policies that once used RPI to track living costs as a way of determining things like benefits and insurance pay outs have shifted towards more accurate measures.

So the latest plans to get rid of it all together sounds sensible and, frankly, not a big enough deal to warrant an entire article on the matter.

Except that not quite everything is pegged to CPIH just yet.

The formal and comprehensive shift would actually help some consumers whose bills and debts are still doggedly linked to RPI by the government, especially rail passengers and those with student loans.

Successive governments have long been accused of “index shopping” – selecting measures of inflation that are lower on outgoing payments like benefits, but pegging some income generating taxes and charges to higher indices. This move would help end all that.

But two groups could lose thousands of pounds each if the plan goes ahead because CPIH tends to be around 1 per cent lower than RPI a year.

Investors in index-linked government bonds or gilts still earn returns on their investments in government debt in line with the RPI measure of inflation.

And those with defined benefit (DB) or “final salary” pension schemes are currently invested in these gilts to the tune of £470bn.

Disappearing trick

Estimates by members of the Association of British Insurers (ABI) have found that implementing the proposed changes in 2025 could leave those affected worse off by up to £122bn by reducing the value of index-linked gilts. Even the latest proposed implementation date of 2030 would only reduce the impact to £96bn, they calculate.

Depending on their age and the timing of the change, individual DB pension scheme members will lose an average of 4-9 per cent of their total lifetime pension income, the Pensions and Lifetime Savings Association (PLSA) has warned.

A man aged 65 in 2020 could see a drop in his yearly average DB income by as much as 17 per cent and a woman of the same age could see her yearly average DB income drop by 19 per cent if changes are made in 2025.

Employers will have to make up the shortfall via increased contributions to close the increase in scheme deficits.

“If ministers force this change through they will reduce the incomes of millions of workers and pensioners and dampen the UK’s long-term economic recovery,” says Laurence Turner, a research officer for the GMB trade union.

“It is outrageous that the Treasury and the UK Statistics Authority have chosen not to consult on their decision to effectively withdraw the RPI, and instead only seek views on its timing.

“We urge ministers to reconsider and withdraw this hugely damaging proposal.”

Even the ABI is calling for the latest possible implementation date to reduce the impact on savers.

“The big question the government needs to answer is the extent to which it will mitigate any negative impact on people with pensions and investments explicitly linked to RPI,” adds Tom Selby, senior analyst at AJ Bell, who suggests one option is to keep a notional RPI for these contracts to adopt. However, that could mean RPI remains a confusing and otherwise redundant part of the system for decades to come.

Nor is the effects on our long-term finances likely to end there.

Despite being widely acknowledged as the most lucrative of workplace pensions, the FCA recently warned that the number of people transferring out of DB schemes has recently risen dramatically. The RPI reforms could increase that trend even further, despite the fact that such a move is rarely in the best interests of the pension holder.