18th May 2020

20-20 Trustees response to RPI reform

In our response to the Consultation on the Reform to Retail Price Index Methodology (“RPI Reform”), 20-20 Trustees has signalled its concern that the proposed change will create significant funding strains for a number of pension schemes and their sponsors. Of course, not all schemes will be negatively impacted, as depending on the structure of the liabilities they may see limited change in their funding, but our response is focused on those schemes that will be impacted.

We do not disagree with the principle of the need for change to RPI or even the proposed calculation methodology. Nor do we disagree with the principle that CPIH (Consumer Price Index Housing) may provide pensioners that have inflation-linked benefits with a more appropriate level of pension increases in some circumstances. Nevertheless, we are fundamentally concerned by the huge transfer of wealth from pension funds to HM Treasury that will occur if no form of mitigation to the proposed change is put in place.

20-20 Trustees propose alignment with a margin

Therefore, 20-20 Trustees mitigation proposal would be to amend RPI to align with CPIH plus a margin. The margin is unlikely to be static, but a transparent margin could be produced which reflects the expected long-term average premium of RPI over the new inflation measure. This reflects pension fund industry norm in designing a suitable CPI hedge with RPI assets. This would provide the certainty that sponsors and pension funds need, and would mitigate the damaging transfer of wealth from asset-owners to asset-writers.

This form of mitigation would also have the structural benefits of maintaining the income profile for pension funds, which is important because the profile of the cash flows are an integral part of the inflation risk hedging mechanism.

Proposals could have negative consequences

Our role as trustees is to be the guardians of hard-earned pension funds. Trustees across the UK have done this by removing risk from defined benefit pension funds and historically investing in index-linked gilts on the understanding they would be uprated by RPI – implicitly recognising the value differences between RPI and CPI. However, the proposed changes provide no compensation for index-linked gilt asset holders and would, therefore, have significant and immediate consequences for many pension funds– especially those with material CPI-linked pension benefit structures.

Under the current recommendation, funding status could deteriorate because when purchased, these assets were bought at a price that reflected the expected cash flows. If the cash flows expected from these assets suddenly reduce (which they would under the proposal in the absence of mitigation), the value of these assets would also fall. This means that pension funds holding index-linked gilts to hedge inflation-linked liabilities will see a reduction in their current asset value as well as future cash flows.

What this means in practice is that a pension scheme that has robust plans in place to minimise risk and has worked hard to ensure the liability is affordable for the sponsor, could face significant problems as a consequence of the proposed changes coming into force without mitigation. The pension scheme would require significantly increased cash funding that the sponsor might not be able to support. These pension schemes may also need to undo some of the asset de-risking in order to obtain additional returns to remove the increased deficit. The resulting unexpected increase in the investment risk would be detrimental to member security and there could be an unacceptable period of time before members’ benefit can be secured.

In addition, an additional deficit could potentially impact on a company’s ability to service debt and pay dividends.  This would jeopardise the company’s financial viability which in turn jeopardises the covenant afforded to the Scheme – essentially once again it will be members who suffer.