February 22nd, 2021

How the change from RPI to CPIH could impact your pension

If you’re a keen saver, you’ll know that it’s important to keep an eye on the rate of inflation as it can erode the value of your money in real terms.

The Treasury has recently confirmed that they will be aligning the Retail Prices Index (RPI) measure of inflation with the consumer price index including housing costs (CPIH) rate by 2030. Whilst this move is expected to have positive benefits for the Treasury, it may also have a significant impact on many pensioners.

If you want to know what this change will mean for your retirement plans, read on to find out how the change from RPI to CPIH could impact your pension.

Critics argue that RPI overestimates the cost of living

The government uses several methods to measure inflation, but two of the most common are the RPI and CPIH. Both methods measure inflation by tracking the change in prices of a basket of 700 goods and services, although the two rates differ due to the way the government measures them.

Whilst the CPIH includes the households of high-earners and pensioners when calculating the rate of inflation, the RPI does not. Since the RPI isn’t fully representative of all UK households, critics argue that it overestimates the cost of living.

On the face of it, a simple change in the way the government measures inflation doesn’t look like a big deal. However, what makes the change controversial is that it is likely to have a negative effect on many people’s pension funds.

Many pensions increase by a small amount each year and this rise is typically linked to the rate of inflation so that their real value isn’t eroded over time.

As you can see from the graph below, the CPIH is typically lower than the RPI, meaning that pensioners are likely to see a smaller annual increase in their benefits.

Source: BBC

The change will affect defined benefit pension schemes

Whilst many public sector pensions are already linked to CPIH instead of RPI, when the government makes the change in 2030 it will affect millions of people who hold private sector pensions. Since the CPIH is typically around 1% lower than the RPI, it means that pensions may grow at a slower rate than expected.

Defined benefit pension schemes will be particularly affected by the change to CPIH as the income that they provide typically rises in line with the RPI.

According to a report by the Pensions and Lifetime Savings Association, the average holder of a defined benefit pension, depending on their age, could be worse off by as much as 9% over the course of their lifetime.

This change will have a significant impact as an estimated 1.3 million people are actively contributing to a defined benefit pension scheme, whilst a further 11.8 million people may be able to claim one in the future.

Furthermore, if you receive an income through an annuity which is set to rise in line with inflation, it could grow at a slower rate.

Whilst the difference between the RPI and the CPIH may appear relatively small, generally only being around 1% lower, the difference could have a significant effect in the long term.

Thomas Selby, from the investment firm AJ Bell, was quoted in the Guardian as saying that over time the difference between RPI and CPIH could “lead to a retirement income worth thousands of pounds less”.

According to a report published by the Association of British Insurers (ABI), published in FT Adviser, the change could wipe out as much as £96 billion worth of pension growth.

This may have a significant impact on many people’s retirement plans, as they may need to reassess the state of their finances since their pension funds grow at a slower rate. Some experts have warned that this shortfall may even require government intervention to resolve.

Index-linked government bonds will see smaller returns

The government has not used RPI as an official national statistic since 2013, although they do still use it when calculating the returns on government-issued bonds. This means that the holders of these bonds, known as index-linked gilts, are set to lose out from this change.

Since the index-linked gilts are linked to the RPI, if this metric were to change to the CPIH, the gilts would also grow at a much slower rate than predicted when they were bought.

According to the report by the Pensions and Lifetime Savings Association, the change to CPIH could reduce the value of these investments by as much as £60 billion.

Since gilts are typically a low-risk investment, they often make up a significant portion of portfolios for people who are approaching retirement. This change may mean that not only will defined benefit pension schemes be affected, but a significant portion of many people’s portfolios may be too.

Thankfully, since the Treasury is expected to make the change to CPIH in 2030, current ten-year index-linked gilts will have time to mature before the change is made, protecting investors who bought them in good faith.

However, if your pension fund will be affected by this change, you may want to consider speaking to a financial adviser who can help you to reorganise your finances to ensure that your long-term plans will not be impacted.

Get in touch

If you are a holder of a defined benefit pension scheme and want to ensure this change does not affect your retirement goals, we can help. Email enquiries@prosserknowles.co.uk or click here to request a call back from one of our advisers.

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