How the inflation measure switch could affect your pension
From 2030, the government will stop using the retail price index (RPI) measure of inflation, instead, it will use the consumer prices index (CPI) measure. While this switch might not seem impactful, it could affect your pension income and other personal finance areas.
The switch has been on the cards for a while, but Chancellor Rishi Sunak confirmed it would go ahead in the November 2020 Spending Review.
What is the difference between RPI and CPI?
Both indexes aim to measure the cost of living and how it is increasing. However, how the figure is calculated varies between the two.
The RPI was first calculated in 1947 and was used for many years as the headline measure for inflation. It has slowly been used less due to “shortcomings in its composition”, according to the government. The CPI was introduced in 1996 to measure inflation consistently across all EU members. So, how do the calculations differ?
The RPI calculates the rate of inflation by measuring the price of various everyday items, as well as housing costs, such as mortgage interest payments and council tax. However, it doesn’t account for some people switching to cheaper products when prices rise.
The CPI calculates inflation by measuring the price of thousands of items that we regularly spend money on, but excludes housing costs. This includes things like cinema tickets or technology. The prices are weighted to give more prominence to what we spend more money on.
Some people argue that CPI is a better measure as it represents a more realistic view of how inflation affects spending.
While RPI has not been used as an official statistic since 2013, it’s still the figure used for some calculations. This includes some pensions, index-linked gilts, and student loan interest. As the RPI is usually higher than the CPI, switching measures could mean that some people miss out.
Switch predicted to cost savers and investors £96 billion
The plans to reform the inflation measure is predicted to cost savers and investors £96 billion according to the Association of British Insurers (ABI). It will particularly affect workers and retirees with a Defined Benefits pension, as it may reduce expected income. Retirees who have taken out an inflation-linked Annuity could also be affected.
Hugh Savill, Director of Conduct and Regulation at the ABI, said: “It is widely accepted that the RPI model is less than perfect, but the proposal’s impact will be felt by policyholders and pension savers for decades.
“Compensation by the government should also be seriously considered to avoid creating winners and losers.”
With the government not commenting on any compensation for those negatively affected by the plans, pension savers, retirees and investors should take steps now to understand if their retirement income will be affected.
Will the inflation change affect your retirement income?
The change could affect anyone receiving a retirement income that is linked to inflation. This is likely to be if you have either an inflation-linked Annuity or a Defined Benefit pension.
Inflation-linked Annuity: This is a product you purchase with a lump sum, usually built up in a Defined Contribution pension, when you retire. It provides you with a guaranteed income for life, increasing each year in line with inflation. Many products will already use CPI as their measure of inflation. If this is the case, you will not be affected by the switch. However, if your Annuity increases according to RPI now, you could lose out in the long run. Check your product documents to see how your Annuity annual rise is calculated and get in touch if you have any questions.
Defined Benefit pensions: Defined Benefit pension holders are likely to be among the most affected by the changes. With this type of pension, you receive a guaranteed retirement income for life, which is usually linked to inflation. Again, if your pension is currently linked to the RPI, you’ll lose out once this switches to CPI. You should check your pension scheme documents to see how annual increases are currently calculated.
At first glance, the difference between RPI and CPI can seem minimal. However, when you factor in the difference it will have on your income over your full retirement, it can be significant. Research conducted by the Pensions Policy Institute (PPI) suggests it could mean Defined Benefit pension members receive up to 9% less from their pension overall.
Daniela Silcock, Head of Policy Research at the PPI, said: “Women and younger pensioners will experience the greatest reduction as women live longer than men, on average, and younger pensioners will experience a compounding effect. Older pensioners on low incomes will also struggle with a reduction in benefits as they have less opportunity to make up income deficits than younger members.”
If you have a retirement income linked to inflation and want to understand what the changes mean for you, please get in touch. We’ll help you understand whether you’ll be affected, the extent of the impact over your lifetime, and what steps you can take to secure the retirement lifestyle you want.
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.
The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.