If you’re building an investment portfolio for retirement savings, it’s a good idea to include some assets with returns that are linked to inflation. Index-linked gilts and National Savings Certificates are two examples. However, increasingly some of these assets remain linked to the older RPI while others link to the newer CPI.
The selection of inflation measure matters because RPI has proved consistently higher than CPI. RPI, at the latest point of measurement, was 3 per cent. CPI for the same 12-month period to April 2019 stood at 2.1 per cent, according to the ONS.
Then there’s the newest inflation index of all, CPIH – CPI plus Housing – which includes owner-occupiers’ housing and council tax costs, in addition to the basket of goods and services selected for CPI. It stood at 2 per cent for the year to April 2019. So why is RPI so much higher than CPI and CPIH, and why does this matter for pension savings? The answer lies partly in the baskets of goods and partly in the calculation method.
Both the CPIH and CPI baskets contain items excluded from the RPI basket, such as university accommodation fees and unit trust commissions. Similarly, the RPI basket contains items, such as estate agent fees, excluded from the CPIH and CPI baskets. The precise weights attached to individual items also differ, but traditionally RPI has placed more emphasis on the costs of running and maintaining a home.
There is one other key difference – both indices build up a stratified sampling approach, but the way CPI is calculated means it returns a lower answer with consumer substitution effects overlaid onto the basket of goods. It accounts for the fact that, when prices rise, some consumers stay brand loyal while others switch brand to find the price they were previously paying.
Given the consistently higher rates of RPI, it’s increasingly controversial that this index is still used to calculate interest on student loans and annual train fare hikes while inflation-based increases in benefits paid out by the government are generally now pegged to the lower CPI rate. This includes the triple-lock increases to the state pension.
Issuers may hope that, with pension-held assets linked to CPI , the difference is so small investors won’t notice. That might be true if you were investing only for a year or two but the power of compound interest means the difference rolls up to become very significant over time.
Actuaries for bank-note printer De La Rue, which recently won a contract to supply polymer for the new £50 note, shaved a cool £80m off its scheme’s liabilities by changing the pensioner indexation from RPI to CPI. That’s out of a total liability figure of £1bn for De La Rue’s closed final salary scheme. This means the actuaries think their pensioners will, over their retirement, be 8 per cent worse off than with RPI indexation.
This isn’t a criticism of De La Rue’s scheme. But it’s a great example of how, in long-term savings, a lot of little differences can add up to a significant change in living standards for future pensioners.
Adrian Boulding is director of retirement strategy at Dunstan Thomas
You can follow him on Twitter @AdrianBoulding