John White explains why the move from RPI to CPI is likely to be high up on trustees’ agendas

When the proposal to index pensions in line with CPI was announced in the emergency budget last year, the initial reaction was mainly one of mild indifference. However, now that it has become a reality, with effect from April 2011, the full implications are being taken more seriously.

Both indices track the changing cost of a fixed basket of goods and services over time, combining around 180,000 individual prices of 650 representative items. Whilst CPI has usually been lower than RPI in the past, what exactly is the difference between the two and how significant will this be for current and future generations of pensioners?

The RPI began life as a compensation index and was dev-eloped as an aid to protect ordinary workers from price increases associated with the First World War. It was only much later that it came to be used as the main domestic measure of inflation.

The CPI is a much more recent development. It was introduced in
1996 and was designed to be an internationally comparable measure of inflation, allowing governments and economists to compare relative inflation between different countries. The Government's inflation target (set at 2% since December 2003) is based on the CPI.

Most of us believe that the main difference between RPI and CPI is the inclusion of certain housing costs (mortgage interest payments, council tax, buildings insurance etc) in the RPI. Whilst this is true, the difference in the movement of the two indices is down to the method of calculation more than anything else. RPI is calculated using the ‘arithmetic mean’, whilst CPI uses the ‘geometric mean’.

Without going into too much detail, RPI takes account of the ‘average’ change in prices over the year – a concept that most of us will have learned at school. In contrast, the CPI uses a more complex mathematical formula, which is thought to better reflect changes in consumer spending patterns relative to changes in the price of goods and services. Readers keen for a more technical description might want to give one of our experts a call when they have a comfortable seat and a few minutes to spare.

So what does this mean in practice?
The Government's stated intention was to introduce a measure that they felt gave a better reflection of inflation for pensioners. The fact that the CPI is (usually) lower than RPI means that the expected cost of publically funded pension schemes will reduce in the short-term, whilst the impact on scheme funding for employers and trustees in the private sector will depend on the wording of the scheme rules – an issue best addressed by the scheme's professional advisers.

Whilst a lower increase in their annual pension will be an obvious blow to those already in retirement, the most pain could be suffered by early leavers from defined benefit schemes. Consider a member who leaves pensionable service aged 40, with his preserved pension being revalued on the CPI basis until age 65. This member will have his pension revalued at the lower rate for twenty-five years prior to retirement, as well as having it linked to CPI in retirement. Assuming the member lives until age 85 and that the annual change in CPI is lower than the RPI by 0.5% throughout the forty-five years of indexation, the ultimate benefits will be 25% less than they would have been if RPI had prevailed. A 1% pa difference in the two indices over the same period would produce a drop of more than 50%.

In summary, far from being a small aside in the emergency budget of June 2010, this change will have significant implications for most pension schemes and we expect it to be an important agenda item for trustee meetings this year.

John White is head of financial management at RSM Tenon
www.rsmtenon.com

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