The reason why defined benefit (DB) scheme sponsors account for inflation is because International Accounting Standard 19, Employee Benefits, tells them that if they make a benefit promise that is linked to price increases, the effect of that commitment has to be accounted for. The starting point for what by any standards is a gargantuan actuarial task is to look at yields on inflation-linked bonds. 

• UK currently has two inflation measures, generating two inflation figures

• Retail prices index is being replaced by the consumer prices index including housing

• Shortage of CPI-linked assets available for hedging strategies

So, take a typical UK DB scheme offering a final-salary pension, backed by scheme assets and linked to one of the two current UK inflation measures – the retail prices index (RPI) and the consumer prices index (CPI) – with a hedging strategy in place. 

RPI has existed since June 1947, but is now seen as an unreliable measure of price increases. In the UK, RPI is still used for a surprising range of purposes such as calculating payments on index-linked Gilts or as the basis for salary negotiations.

Unsurprisingly, the two different measures produce two different estimates of 12-month inflation. The difference between the two measures is known as the Wedge. This effect is typically down to the effect of:

• The formula – RPI is calculated using an arithmetic formula whereas CPI relies on a geometric formula;

• Housing – CPI excludes housing costs whereas RPI includes them;

• Coverage – RPI and CPI include and exclude different items;

• Weighting – the two methodologies weight different purchases differently.

Following a 2013 consultation, the UK’s statistics chief ruled the formula behind RPI no-longer satisfied international norms. Five years later, Bank of England’s governor Mark Carney said it should be dropped.

More recently, in March, the Office for National Statistics (ONS) launched a consultation into the future of RPI. The ONS proposed replacing RPI with the CPIH measure of CPI, which is CPI plus owner-occupier housing costs. The earliest this change could occur is 2025, although the ONS can make the shift of its own volition from 2030.

Accounting for all of this in practice, explains Aon partner and consultant actuary Lynda Whitney is a challenge: “Although we know quite a bit about RPI, CPI is less well traded and that means we don’t have direct visibility on it and the difference isn’t stable. At the moment we know it isn’t stable because of the ongoing consultation process and the change that will kick in from either 2025 or 2030.

Lynda Whitney

“What we are seeing is that the gap between the two measures has shrunk because people think they will get less from an RPI Gilt going forward because CPI is a lower measure of inflation than RPI.” This is because one of the groups that stands to lose out if RPI is calculated on the same basis as CPIH are holders of UK Gilts. 

She adds: “If I were looking at RPI today, I’d probably knock off half a percentage point to arrive at CPI; a couple of years ago, that adjustment was likely to have been a 1% adjustment. So, while you can see movement in RPI, you need to understand why that movement is happening. Once you know that, you are in a better position to arrive at a value for CPI.

“The purpose of the adjustment is to take account of future expectations – a curve over the future. You could argue that from 2030, say, RPI will be equal to CPI and that there will be no gap. But what the market appears to be doing is weighting that likelihood with the possibility it doesn’t happen. So, the Wedge could go all the way to zero if this proposal goes ahead, which, if you think back to that half-percent adjustment I mentioned, leaves us about half way there at the moment.”

In addition, some sponsors contend that IAS 19, because of its reference to unbiased assumptions, gives them a green light to deduct an inflation risk premium from their break-even inflation figure. Survey data from earlier this year compiled by Hymans Robertson show that about 77% of FTSE 350 in fact do. This adjustment is intended to reflect the premium that investors are prepared to pay in excess of the likely outturn on inflation.

Of course, it is necessary to find evidence to support this deduction, which has the effect of lowering inflation assumption. But, those trying to keep consistency between their treatment of assets and liabilities, and using inflation hedging in their asset strategy, are locking into market rates. So, it could be argued that even for those who believe an inflation risk premium exists, it is wrong to allow for it.

So what conclusions can be drawn? “The consultation could lead to a step change in 2030 or earlier,” says Hymans Robertson partner and actuary Matt Davis. “RPI market pricing out to 2030 is at broadly similar levels to what we’ve seen in recent years, implying year-on-year RPI of around 3% to 3.5% per year. 

“If market pricing fully reflected RPI reform going ahead by 2030, you’d expect to see a step change down in year on year RPI rates beyond 2030. However, what we are actually seeing at the moment is that from 2030 it takes a further 20 years or so for market implied RPI to gradually drop down towards the Bank of England CPI target of 2% per annum.”

Essentially, the approach is all about pricing the best information you have in. Sometimes people only make one adjustment over the curve, says Whitney. This is because what they are doing is averaging the difference between the reporting date and the point in time when the switch will occur.

As might be expected, the effect of the shift from RPI to CPI will depend on a scheme’s assets, its liabilities and its hedging position and their interaction. 

“A scheme that is matched in terms of RPI assets and an RPI obligation probably doesn’t mind because they are matched and hedged,” says Whitney. “When you do care is when you have RPI-linked assets and liabilities linked to CPI. This is because for every 0.1% drop in RPI – subject to the duration – you have a 20-fold impact on the actual liability. And that mismatch in hedging is when the whole issue becomes more problematic for sponsors.”

So, where does this leave scheme sponsors? “In terms of IAS 19,” says Davis, “people should be aware that this is an assumption where there is more judgement involved at the moment than there has been in the past. You need to take account of how much market rates reflect how RPI reform might play out. You also need to know that once the consultation outcome is known it might lead to a situation where the assumptions need to be changed. 

“And from a wider pensions management scheme, sponsors must understand the level of inflation exposure they have in their scheme and check that they are comfortable with their hedging strategy.”

Both Whitney and Davis agree that it is difficult to obtain CPI long-dated assets to hedge CPI-linked inflation so schemes normally use RPI instruments. What is more, there is a risk that there could be a drop in the value of assets with no change in the value of liabilities.

Well, no-one said this was easy.