Paul Leatherbarrow, Liverpool
Most of the British public do not understand the government’s plans to link public and state pensions to the consumer price index (CPI) instead of the retail price index (RPI) and more importantly why.
The move from RPI to CPI is this government’s equivalent of linking the basic state pension to prices rather than earnings back in 1980. This was a technical move which took many years for the impact to be understood. If the basic state pension had remained linked to earnings it would be worth £158.6o instead of £97.65. Like the change back in 1980 it will take a few years before the impact is felt. At present the CPI IS typically 0.7 % lower, which in turn means funds will be lower.
CPI is the measure adopted by the Government for its UK inflation target. The Bank of England's Monetary Policy Committee is required to achieve a target of 2 per cent. In the June 2010 Budget, the Chancellor announced the Government’s intention to also use the CPI for the price indexation of benefits and tax credits from April 2011. Prior to 10 December 2003, the CPI was published in the UK as the harmonised index of consumer prices (HICP).
The uses of the RPI and its derivatives include indexation of index-linked gilts. Historically the RPI has also been used for indexation of pensions and state benefits.
Inflation is the percentage change in the index compared with the same month one year previously.
CPI - The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The CPI provides a way for consumers to compare what the market basket of goods and services.
RPI - The Retail Price Index (RPI) is the main domestic measure of inflation in the United Kingdom. The survey is conducted by the Office for National Statistics and measures the average change in prices of goods and services purchased by most households in the United Kingdom. The index is compiled using a large representative selection of more than 600 separate goods and services for which price movements are regularly measured in 146 areas throughout the country. Some 120,000 price quotations are used each month in compiling the index.
What’s the difference?
The CPI includes different things: spending by pensioners who get most of their income from state benefits is included in this measurement, while council tax and mortgage payments are excluded. The effect of this has usually meant that the CPI inflation measure is lower than RPI inflation, though it can have the opposite effect.
The CPI also makes price increases look smaller because it takes account of how consumers switch to alternative products to avoid them. How does this affect me?
On average, you could expect CPI inflation to be roughly 0.5% to 0.75% a year below RPI inflation, but the gap is forecast to be bigger in each of the next five years.
Using the CPI as the measure for determining increases to pensions, a pensioner currently receiving £10,000 a year would see a pension of £11,400 rather than £12,200 in 2016 – a drop of just over £15 per week.
The coalition government has always made it clear that the public sector would have to offer less generous pensions in future, but also insisted that promises made to date would be honoured. The switch of inflation measure has therefore come as a surprise because it directly affects the pensions that people were already expecting.
Is CPI a better way of measuring inflation?
• It will mean lower pension increases in the short term and, for the government, a welcome contribution to cutting the deficit.
• In view of the government’s decision to move the inflation measure, is it likely that companies in the private sector will follow suit?
• The government will now use CPI inflation to calculate “revaluation orders”. These are the numbers most schemes use to ensure a final salary pension keeps pace with inflation between the time a member leaves their job and retirement.
• If this gap is big and mostly ahead of you, you have probably lost money.
• The effect of these differences is that uprating on the basis of CPI is on average about 1% less than uprating on the basis of RPI. One percent may not seem very much for one year, but the cumulative difference will become substantial over the course of a retirement lasting a number of years. After 10 years in payment a pension increased on the basis of CPI would be worth about 10% less than one based on RPI increases. After 20 years, when the pensioner would be 80, his CPI increased pension would be worth about 20% of what it would have been under RPI. If he should be fortunate enough to survive to be 90 his CPI pension would be worth 30% less than an RPI one.
Once pensions are actually being paid out, things become more complicated.
Prior to changes introduced in 1997, employers were able to provide final-salary pensions which would not increase with the cost of living once in payment. Post 1997, when employers were forced to apply inflation protection to new pension promises, they were offered two ways of doing this.
1) The first option was simply to define pension increases by reference to whatever minimum rate the law required. If your employer took this route, part or maybe your entire pension will now go up with CPI inflation after retirement. If you are already receiving a pension you will be affected by this change next year.
2) Instead of referring to “whatever is the legal minimum”, some schemes chose to write the pension increase formula into their rules.
3) Most companies which voluntarily provided pension increases before 1997 complied in this way, so they could continue what they were doing already.
4) Even when the legal minimum becomes CPI-based, pensioners in these schemes are likely to remain entitled to RPI-linked increases as long as the rules themselves refer to RPI.
5) Depending on precisely how the law changes, there is even a chance that some pensioners could become entitled to an increase based on whichever measure of inflation is highest. If we returned to the conditions seen in 2009 and much of the early 1990s, when CPI inflation was the higher of the two, pensioners would then be entitled to more money at their former employers’ expense.
The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.
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