1. RPI VS. CPIMAGIC NEW FORMULA WILL LEAD TO SHRINKING WEDGEOCTOBER 2012
2. www.redington.co.uk/www.pensioncorporation.com 1Executive SummaryBackgroundThe difference between RPI and CPI as inflation measures has been a statistical nuisance tounderstand and explain for the UK government for some time.The difference stems from two factors:1) Composition; CPI excludes housing and council taxThis has historically accounted for the larger part of the difference though theeffect can be in either direction.2) Formula EffectThis has accounted for a smaller part of the difference, but the effect consistentlybiases RPI above CPI. The effect increased in January 2010 to around 100bps,driven largely by changes to the methodology in the measurement of clothingand footwear 1..The Consumer Prices Advisory Committee (CPAC), whose role is to advise the UKStatistical Authority (UKSA) on the measurement of inflation, has initiated a managing theformula effect (MFE) programme to “identify, understand and remove unjustified causes ofthe formula effect gap”. This is important as approximately 75-100bps of the “wedge”between CPI and RPI is derived from the difference in the formula chosen to assess andcollect data.In light of their findings, the CPAC are in consultation to reduce and potentially eliminate thegap through data stratification and/or changing the current RPI methodology. Fouroptions are being assessed ranging from “do nothing” to “full alignment between RPI andCPI”. Expected from 2013, it is anticipated that there will be some convergence with theeffect of reducing the RPI. General market expectation is a long term fall in RPI of around50-75bps. The 15-year RPI expectation implied by index-linked gilts market has fallen toaround 2.35% p.a which is 70bps below its peak from its peak in April this year and about50bps below the position on 18 May 2012 when the consultation was announced.Possible impactAny moves to narrow the RPI/CPI wedge could impact: Issuers of index-linked bonds – both Government and private sector Buyers who may start pricing in a “political risk” of further future changes tocalculation methodologies. Holders of the £177billion of index-linked gilts (“linkers”) in issuance1ONS – CPI and RPI: increased impact of the formula effect in 2010
3. www.redington.co.uk/www.pensioncorporation.com 2 RPI swaps participants Pension schemes with RPI liabilities Pensioners with RPI-linked benefitsKey considerations for pension schemesThis possible change, like the previous move to change statutory indexation from RPI toCPI, highlights the need for pension schemes to fully understand the financial implications ofinflation on their liabilities and to hedge them.Lower inflation and expectations of future inflation will, other things being equal, lead to adecrease in scheme liabilities. To the extent that schemes have hedged their exposure toinflation, they will of course neither participate in the positive effects of falling inflation or thenegative effects of rising inflation.The Redington/PIC survey published in 2011 highlighted that on average, UK pensionschemes had hedged only 25% of their inflation exposure. This leaves them significantlyexposed to moves in inflation.Recent Developments Latest September CPAC minutes announced a consultation commencing 8 October2012 to invite users’ views on the options for the way RPI is calculated. The optionspresented were:1. No change2. Change approach to averaging prices for some categories3. Change approach to averaging prices for all categories that use theCARLI or arithmetic averaging approach (see section 1 for moredetails)4. Change RPI so formulae fully align with CPI The consultation is expected to run to the end of November 2012 at which point, theCPAC will reconvene to consider the responses including any recommendations bythe National Statistician. Market pricing is likely to build in changes when they become likely, ahead of actualimplementation. Recent fall in market implied inflation (20-25bps) between April 2012 and 1 October2012 could be attributed in part to expectations of CPAC action.
4. www.redington.co.uk/www.pensioncorporation.com 3Next Steps If changes were to be proposed, these would be introduced with the annual update ofthe RPI when it is published on 19 March 2013. Although the Chancellor of the Exchequer must gives its final approval to anyproposed changes to RPI methodology should the Bank of England find them“materially detrimental to the interests of the holders” of index-linked gilts, this is notan insurmountable condition to getting the RPI to narrow towards CPI. It is unclear whether there has been any precedent for what constitutes “materiallydetrimental” in such circumstances. However, changing RPI and by implicationlowering it towards CPI would potentially bring into opposition the interests of linkerholders and HM Treasury. Assuming the CPI target is not revised higher tocompensate the loss of the formula effect wedge, then all other things being equal,the future value of RPI cashflows (and hence linkers, and breakeven inflation swaps)should fall.
5. www.redington.co.uk/www.pensioncorporation.com 4Table of Contents1. BACKGROUND .............................................................................................................. 52. THE ONS, CLOTHING AND WEDGES.......................................................................... 73. ENTER CPAC ................................................................................................................. 84. CONCLUSION .............................................................................................................. 11
6. www.redington.co.uk/www.pensioncorporation.com 51. BackgroundHistory of CPI vs. RPI2Fundamental differences between the Consumer Price Index (CPI) and Retail Price Index(RPI) as measures of inflation can be outlined as follows:1. Composition Effect – Housing costs and council tax are not included in CPI,whereas it is included within RPI.2. Formula Effect - CPI uses a geometric mean of relative prices whereas RPI useseither an arithmetic mean of relative prices OR a ratio of average prices betweenmonths.The key point is that the differential or “wedge” between the CPI and RPI has meant that fora 2% CPI target in steady state, you can expect a higher RPI level of c.100bps3. This ispartly a mathematical effect. The gap in individual years is volatile and can be materiallyhigher or lower than 100bps. Indeed, CPI has exceeded RPI in several individual years. Butaveraged over the long term RPI (if methodology is unchanged) is very likely to exceed CPI.The Formula EffectThe first few steps of the calculation of inflation between two periods involve the collection ofa number of price quotes in both periods from retailers or suppliers. These quotes are thenin some way averaged and a relative change established from one period to the next.There are several mathematical approaches to the averaging and ratio calculation, which areused both within the RPI and CPI methologies in addition to standard weighted averaging : CARLI – Average of price relativesTakes the ratio of a matched pair of prices in both periods and takes thearithmetic average of all ratios in a well defined group of products JEVONS – Ratio of average pricesGeometric mean of price ratios or ratio of geometric mean prices DUTOT – Ratio of average pricesTakes an arithmetic average in both periods, of all prices in a well definedgroup of products and takes the ratio of those averagesSource: ONS user engagement July 20122Please refer to section 3 of our December 2011 paper - “UK Final Salary Pension Schemes: Inflation Hedgingand the change in Indexation from RPI to CPI survey results”, which discusses these differences and theircontribution to CPI/RPI basis risk in more detail.3ONS: Economic and fiscal outlook March 2011.
7. www.redington.co.uk/www.pensioncorporation.com 6The application of the different methodologies as a proportion of the RPI and CPI iscompared below:CPI RPI30% JEVONS 25% CARLI30% DUTOT 30% DUTOT40% Weighted average 45% Weighted averageSource: ONS user engagement July 2012The formula effect arises due to the difference in the JEVONS and CARLI methodologiesused within 25-30% of each index. A large part of the methodologies behind each index arein fact the same.Other countries around the world, particularly the EU, use methodologies similar to theJEVONS.
8. www.redington.co.uk/www.pensioncorporation.com 72. The ONS, Clothing and WedgesBack in 2010, the Office for National Statistics (ONS) changed the methodology forcollecting clothing prices. They applied a less stringent standard to allowing items to enterthe clothing basket by allowing price comparisons to be included where there had been asmall change to the characteristics of a piece of clothing from one month to the next. Thereasoning behind this being - fashions change, so why only include items that are stuck onthe rails from last month? In addition, seasonal items were also included (boots, beachwearetc) rather than only items that were likely to be featuring in the basket throughout the year.Sale items were also included in the price quotes.The impact of the 2010 changes in including changing fashions and seasonal items was tomake the basket of goods more variable month on month and that variability broadlytranslates into a larger CPI vs. RPI wedge. This is because, while the RPI and CPI have thesame clothing basket, increased variability accentuated the formula gap by increasing thedispersion of the price relatives. In monetary terms, the 2010 changes were seen by someinvestment banks as causing the move in size of the formula effect from approximately50bps since 2009, to 100bps in 2011 of RPI over CPI4. At the time, the changes wereintended as a way of drawing more items into the “basket” to create a more representativesample for RPI/CPI calculations.4Morgan Stanley – February 2012: A New RPI-CPI Wedge?
9. www.redington.co.uk/www.pensioncorporation.com 83. Enter CPACThe Consumer Prices Advisory Committee (CPAC) began investigating the formula effectin May 2011. This became a programme of managing the formula effect (MFE) with thepurpose to “identify, understand and remove unjustified causes of the formula effect gapbetween the CPI and RPI”5.The minutes of the July 2012 CPAC meeting noted that the CPAC are making progress withthe MFE programme. Any recommendations from the CPAC to change the UK inflationmeasures in light of their findings could have implications for several areas if suchrecommendations are then adopted by the ONS and approved by the Bank of England(BOE) and UK Government.Minutes Release – Impact on Gilt Breakeven InflationFigure 1: 15-Year Gilt Breakeven Inflation (as at 2 October 2012)Source: Bloomberg, RedingtonIn the two weeks following the release of the CPAC minutes on 18 May, 15-year breakeveninflation dropped by more than 25bps in anticipation of a narrowing gap between the RPIand CPI. Though the downward trend continues, other factors have also weighed on thedecline of breakeven rates such as the renewal of BoE quantitative easing programme andrecent sharp falls in oil prices. US and European markets have also seen sliding inflationfrom respective policy interventions interacting with economic outlook.5CPAC Papers – April 2012 meeting: Progress Update on Managing the Formula Effect22.214.171.124.126.96.36.199.03.1%18 May 2012: CPACminutes released18 Sep 2012: CPACminutes released
10. www.redington.co.uk/www.pensioncorporation.com 9What can you “improve” if you want to have a smaller formula effect?StratificationOne way of managing down the price variability is to stratify the data. For instance, bydifferentiating between supermarkets, departments stores, discount outlets, online etc ratherthan simply by “independent” and “multiple” retail outlets as is currently the case.Unfortunately, stratification by itself only removes a small part of the formula effect.FormulaThe second way of reducing the formula effect is to change the methodology. For example,by calculating RPI using the geometric rather than the arithmetic average.Out of the September CPAC meeting, a consultation document is to be published on 8October 2012 to invite users’ views on a range of options, ranging from no change to a fullalignment of the RPI formulae to CPI6.It is important to note that there is more than one change being proposed here. Firstlystratification and secondly changing the actual calculation for RPI from an arithmetic mean togeometric mean. Although both will have the impact of reducing the formula effect, thecompositional impact remains from housing prices in RPI. This had been anticipated by theCPAC and in June 2012, the ONS announced a consultation on the inclusion of housingcosts in CPI7.Hurdles to RPI changesThere are hurdles to simply changing RPI methodologies, not least the impact on the UKindex-linked gilts market. The formal process differs for some traditional 8-month lag linkersversus the newer 3-month lag linkers, however, in summary the parties involved in thedecision process are the UK Statistical Authority, the Bank of England and, ultimately, theChancellor of the Exchequer.Bondholder ProtectionThe Statistics and Registration Service Act which covers changes to RPI provides someprotection to bondholders. Investors holding the traditional 8-month index-linked gilts will beable to redeem their bonds. However, it seems they would only receive the accrued indexratio to date. In the current low yield environment, redeeming these bonds which, in mostcases, had been issued with a coupon higher than current rates, would mean the investorwill receive a price less than the actual market value of the bond.6ONS – CPAC September 2012 Meeting Summary Note7ONS: Consultation on the recommended method of reflection owner occupiers’ housing costs in a newadditional measure of consumer price inflation, and the strategy for Consumer Price statistics
11. www.redington.co.uk/www.pensioncorporation.com 10However, the protection for the 3-month linker holders is less than that of the 8-month linkersand in summary, there is nothing in the documents that prevents a change to the index.Nevertheless, before making any changes to the RPI, the UKSA must “consult the BOE asto whether the change constitutes a fundamental change in the index which would bematerially detrimental to the interests of the holders” of index-linked gilts. If the BOE doesconsider the changes to be materially detrimental then the UKSA may not make the changeswithout approval from the Chancellor of the Exchequer.It is unclear whether there has been any precedent for what constitutes “materiallydetrimental” in such circumstances. However, changing RPI and by implication lowering ittowards CPI would potentially bring into opposition the interests of linker holders and HMTreasury. Assuming the CPI target is not revised higher to compensate the loss of theformula effect wedge, then all other things being equal, the future value of RPI cashflows(and hence linkers, and breakeven inflation swaps) should fall.
12. www.redington.co.uk/www.pensioncorporation.com 114. ConclusionWhere does it lead?The face value of the UK linker market stands at £177bn8and given the potential cost and/orneed for compensating bond holders, one would think that much will depend on approvaland consultation. However, given the level of access of the CPAC to the Bank of Englandand HM Treasury to discuss the issue, this gives the impression this process is being takenseriously and that legislation has a chance of passing.If the CPAC is successful in achieving its mandate of “identifying and eliminating unjustifieddifferences” between CPI and RPI, the formula effect will effectively be eliminated, and amajor precedent will have been set.Key considerations for PensionsAt a fundamental level, the indices are alternative measures which is why we have tworather than one inflation index. Without getting into the argument here of which is a betterrepresentation of the cost of living for retirement benefits, the likely effects of eliminating“unjustified” differences from the formula effect are: The convergence of the RPI and CPI index, most likely in the direction of RPIdecreases rather than CPI rises Market expectations of moves in inflation will continue to be priced and reflectedwithin the respective bonds and swaps markets While liabilities remain indexed against the RPI, index-linked gilts and RPI swaps willcontinue to function as liability matching instruments.Although the extent and timing of the changes are liable to remain uncertain in the comingmonths, the narrowing of the RPI to CPI wedge highlights the reality that general inflationrisk poses a much greater risk to most schemes than the basis risk between the two. Theindustry revisits a question raised by the previous move to change statutory indexation fromRPI to CPI; are trustees / sponsors truly aware of the overall financial implications of inflationon their pension scheme liabilities?Lower actual inflation as well as expectations of future inflation will, other things being equal,lead to a decrease in scheme liabilities. To the extent that schemes have hedged theirexposure to inflation, they will neither participate in the positive effects of falling inflation orthe negative effects of rising inflation.At first thought, there may be an inclination to wait in the idea that inflation hedging will becheaper in the near future, given the anticipated fall in the relative index. However, marketsalso react to information and there is evidence that inflation markets (e.g. Index-linked gilts,8DMO – June 2012: Index-linked gilts in issue.
13. www.redington.co.uk/www.pensioncorporation.com 12swaps) have already begun to price in the possible changes. Attempting to call the inflationmarket is therefore no easier now than it was before.The Redington/PIC survey published in 2011 highlighted that on average, UK pensionschemes had hedged only 25% of their inflation exposure. Irrespective of the outcome of thecurrent consultation, this leaves them significantly exposed to moves in inflation.The priority of these schemes should be to increase overall levels of inflation protection.There is a risk that the current uncertainty over the RPI calculation method will lead toinaction in the hope of cheaper hedging opportunities in the future. Instead, schemes shouldrecognise that inflation is one of their largest unhedged risks. As demonstrated by the break-even charts, hedging instruments such as index-linked gilts and inflation swaps have alreadyallowed for the expected/possible change in RPI calculation methodology.A more significant problem posed may be the limited supply of hedging instrumentsavailable on the market. Currently, versus a total pensions liability of c.£7 trillion9, the UKonly has £335 billion of inflation-linked gilts, c.£30 billion of UK corporate index-linked bonds(e.g. utility companies), and a further estimated £100 billion in the inflation swap market.9ONS, A fuller picture of the UK’s funded and unfunded pension obligations, April 2012