£96 billion inflation blow for pensioners and investors

Since the last Budget, the government and UK Statistics Authority (UKSA) have been reviewing RPI (Retail Prices Index) and planning on making it more like CPIH (Consumer Prices Index including owner occupiers' housing costs). On Wednesday, as part of the spending review, these plans were confirmed.

What is RPI and what’s so wrong with it?

RPI is one of the main ways we calculate how much prices have risen for financial products. The inflation measure is used when determining increases in lots of things like private pensions, rail fares, duty rises and student loan rates.

The problem with RPI became clear around 2010. That’s because the range of clothing in the basket of goods used to calculate RPI was expanded to make it easier to compare through the seasons. As a result, there was a spike in inflation for clothing that the ONS called ‘implausible’. The problem ultimately comes down to how RPI averages things out – it tends to exaggerate rises.

RPI has since been dropped as an official inflation measure. It’s mainly just been kept as a legacy measure because so many things are linked to it throughout the economy.

CPI was introduced as a European measure, and CPIH is a variation that takes into account the cost of housing. It’s become the government’s measure of choice. CPIH calculates its averages differently to RPI, so tends to be consistently lower.

Is the change good or bad?

It depends who you are. On one hand, it’s good news as it’ll stop the government from going inflation shopping – linking things we pay the government to higher RPI, like interest on student loans and car tax. And linking government spending, like income from some index-linked bonds, to the lower CPI. But on the flip side, the switch could cost investors and pensioners a hefty £96 billion.

Phil Warner, Head of Regulatory Advice and Policy, Hargreaves Lansdown said:

“We believed that RPI should have continued to be published in its existing form. Not because it’s accurate, or correct, but because pensioners should continue to receive the pension income they have paid for and it is right for the government to maintain trust in pensions.”

Who will pay the price?

The changes won’t take place until at least 2030, but it’s important to know if you’ll be affected.

• Final salary pension scheme members

Nearly two thirds of private sector defined benefit schemes link rises in pension income directly to RPI. So switching to a lower measure of RPI could mean lower future incomes in retirement. This doesn’t just affect today’s retirees, but millions of workers paying into these schemes too. However, this is a sensitive issue, so it might trigger legal challenges – which makes the final impact difficult to judge.

• Annuity holders with RPI guarantees

In return for a lower starting annuity income, you can choose to have your income move in line with the RPI. This means your income will keep its buying power by tracking inflation.

If you’re looking to buy an index-linked annuity, the change to RPI might be priced in by insurers, so you won’t necessarily lose out. On the other hand, you might find that you end up overpaying to shelter your income from inflation. As always, you should think about what’s right for your circumstances when making this decision. If you’re unsure, you should ask for advice. The government's Pension Wise service also offers a free impartial service to help you understand your retirement options.

If you’ve already bought an index-linked annuity, changes to the index are likely to see your retirement income rise more slowly. That’s because CPIH normally tends to be about 1% lower than RPI.

• Bond investors

If you have index-linked bonds in your investment portfolio, the change will mean lower index-linking (assuming your bonds are linked to RPI). Their value is also likely to fall, as investors now see them as less attractive. Remember all investments fall as well as rise in value, so you could get back less than you invest.

This article is not personal advice. If you are unsure of an investment or course of action for your circumstances, please seek advice.