The document discusses the implications of changing the inflation index used for statutory indexation of UK pensions from RPI to CPI. It provides background on the difference between the RPI and CPI baskets and historical differences in their rates. It summarizes views from various parties on expected long-term differences between RPI and CPI inflation. The document also examines the impact of the change on pension schemes, insurers, and hedging strategies. A survey of actuaries and trustees finds most expect CPI to be 0.5-1% lower than RPI long-term but strategies for schemes that can switch to CPI vary.

1. © 2010 The Actuarial Profession  www.actuaries.org.uk
Robert Gardner, Redington
Jay Shah, Pension Corporation
Investment Implications
of RPI to CPI
4 October 2011

2. The Inflation basket
1© 2010 The Actuarial Profession  www.actuaries.org.uk
RPI:
+ Financial Services

3. What has happened
2© 2010 The Actuarial Profession  www.actuaries.org.uk
Legislative changes
Proposed switch in
statutory indexation:
RPI to CPI
Implementation
8 December 2010
Consultation
launched
8 July 2010 6 April 2011

4. RPI vs. CPI
3© 2010 The Actuarial Profession  www.actuaries.org.uk
Why it’s happened
• CPI is BoE’s
benchmark for the
whole economy
• Only 7% of
pensioners have
an outstanding
mortgage
1
2
3
Standard Deviation:
•RPI 1.54
•CPI 1.02
Source: ONS
• (Reduce public pension liabilities...)
-2
-1
0
1
2
3
4
5
6
Percentage
RPI (y/y) CPI (y/y)

5. How it’s happened
4© 2010 The Actuarial Profession  www.actuaries.org.uk
Public sector
• Pensions in payment increases indexed to CPI,
• capped at 5%
Private
• No mandatory statutory override
• No enabling modification power
• No CPI underpin required
• New pension consultation requirement

6. Risk management
UK inflation – the long run
Long run difference
• Aggregate price changes
• Mathematical formula
• 2010 formula effect to
persist
• Permanent 0.3% difference
implied
• Long-run estimate of 1.2%
“wedge”.
5© 2010 The Actuarial Profession  www.actuaries.org.uk
Formula effect
Source: ONS

7. Risk management
UK inflation - April 2011
• CPI jumped from
4% to 4.5% in April
• Currently remain
above forecasts of
4.1%
• RPI floats around
5.2%...
6© 2010 The Actuarial Profession  www.actuaries.org.uk
CPI up, RPI down
Source: ONS, Redington
0
1
2
3
4
5
6
Percentage
RPI (y/y) CPI (y/y)

8. Risk management
Hedging inflation
7© 2010 The Actuarial Profession  www.actuaries.org.uk
Finding relative value
Source: Bloomberg, Redington
-1.50
-1.00
-0.50
0.00
0.50
1.00
1.50
2.00
30y Swap Real Yield 20y Gilt Real Yield 30y Swap Spread (Swap Yield - Gilt Yield)

9. Risk management
Hedging CPI Swaps Pricing*
8© 2010 The Actuarial Profession  www.actuaries.org.uk
• 20 year RPI 3.475% - 3.575%
• (Mid – 3.525% and 5bp spread)
• 30 Year RPI 3.927% - 3.655%
• (Mid – 3.605% and 5bp spread)
• Vs
• 20 year CPI 2.852% - 3.252%
• (Mid – 3.052% and 20bp spread)
• 30 Year CPI 2.927% - 3.327%
• (Mid – 3.127% and 20bp spread)
RPI/CPI spread
• 20 year CPI Mid – 3.052% and 20 year RPI
Mid – 3.525%
• = -0.473% with at least 20bps spread.
• 30 year CPI Mid – 3.127% and 30 year RPI
Mid – 3.605%
• = -0.478% with at least 20bps spread.Source: RBS

10. Risk management
Hedging inflation
9© 2010 The Actuarial Profession  www.actuaries.org.uk
Hedging CPI
Physical assets
• CPI-linked gilts?
• Flight Plan
Consistent Assets
(FPCA)
• CPI bond market...?
CPI

11. Risk management
Alternative Sources of CPI
10© 2010 The Actuarial Profession  www.actuaries.org.uk
-6
-4
-2
0
2
4
6
8
0 5 10 15 20 25 30
GBPMillions
Years
Initial investment
Attractive real returns
Inflation-linked cashflows
Providing a match for liabilities
Inflows
Outflows
Source: Redington
Flight Plan Consistent Asset – Example Cashflow Profile

12. Risk management
Alternative Sources of CPI
11© 2010 The Actuarial Profession  www.actuaries.org.uk
Most Risk
Pricing mechanism
Least Risk
Sector
Availability Regulatory Demand Economic Price
Most RiskLeast Risk
Source: Evolution Securities, Redington

13. Recap of bulk annuity market growth
12© 2010 The Actuarial Profession  www.actuaries.org.uk
Column: Stack
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
2004 2005 2006 2007 2008 2009 2010
(£ million)
Pension insurance
buyout / buy-in
Pension insurance buyout CAGR¹: 66%
Longevity insurance
Market growth maintained Transactions examples

14. Reaction of schemes looking to de-risk
• How does this impact us?
– In payment : RPI generally hard-coded
– In deferment : reference to statutory revaluation
• ETVs and PIE exercises put on hold
• Buy-in / Buy-out decisions delayed
13© 2010 The Actuarial Profession  www.actuaries.org.uk

15. Pension scheme view of CPI vs. RPI
14© 2010 The Actuarial Profession  www.actuaries.org.uk
RPI vs CPI Index: January 1988=100
75
100
125
150
175
200
225
1988
01
1989
01
1990
01
1991
01
1992
01
1993
01
1994
01
1995
01
1996
01
1997
01
1998
01
1999
01
2000
01
2001
01
2002
01
2003
01
2004
01
2005
01
2006
01
2007
01
2008
01
2009
01
2010
01
RPI rebased
CPI rebased

16. Expectations of RPI to CPI gap
15
Party / Source RPI-CPI assumption
The Office for Budget Responsibility, Economic and
Fiscal outlook of March 2011
1.2%
FTSE350 Pension Fund accounting disclosures,
Hymans Robertson’s 2011 survey
0.7% to 2.8%
Mercer briefing July 2011 0.5% to 0.8%
Investment Bank instruments 0.1% to 0.2%
Our survey See later slides

17. Insurer view of CPI vs. RPI
16© 2010 The Actuarial Profession  www.actuaries.org.uk
RPI vs CPI year on Year since 1989
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
1989
09
1990
09
1991
09
1992
09
1993
09
1994
09
1995
09
1996
09
1997
09
1998
09
1999
09
2000
09
2001
09
2002
09
2003
09
2004
09
2005
09
2006
09
2007
09
2008
09
2009
09
YoY % increase RPI
YoY % increase CPI

18. RPI v CPI: Historic differences
• The average annual RPI-CPI gap from May 1997 to July 2011was 0.88%
• Annualised standard deviation of monthly observed RPI-CPI basis was
1.27%
• RPI was above CPI for 85% of the period
– Main period of negative RPI-CPI due to rapid mortgage cost inflation
reduction over 2008
17

19. RPI v CPI density function
18
Histogram of RPI-CPI since May 1997 and approximated density function
Abnormal – e.g. falling interest rates
mean of – 2.9% (CPI higher)
Normal : mean of 1.1%
(RPI higher)

20. RPI vs. CPI – stochastic simulation – no
underpin
19© 2010 The Actuarial Profession  www.actuaries.org.uk
Source: Barrie and Hibbert

21. RPI vs. CPI – stochastic simulation – with
underpin!
20© 2010 The Actuarial Profession  www.actuaries.org.uk
Source: Barrie and Hibbert

22. CPI, RPI and base rates
21© 2010 The Actuarial Profession  www.actuaries.org.uk

23. Hedge with RPI – implications for insurers
• 1 in 200 year test – capital requirements
– statistical variation
– changes in the basket of goods
– changes in calculation methodology
– political influence
• Shock effects if CPI market develops differently
• Impact of caps and floors:
– Volatility of CPI is lower than RPI
– So floor and cap both less likely to bite? Net impact?
22© 2010 The Actuarial Profession  www.actuaries.org.uk

24. Hedge with CPI
23© 2010 The Actuarial Profession  www.actuaries.org.uk
• Investment Bank A : CPI vs RPI = 0.1%
• Investment Bank B : CPI v RPI = 0.2%
• Capacity available : Small
Instrument Approx market size
Indexed RPI gilts £270 bn
Indexed RPI bonds £30 bn
RPI Inflation swaps £100 bn
CPI linked Virtually nil

25. Insurer solutions
• Insure on CPI but no discount to RPI
– Benefits indexed to CPI
– Expected CPI under-run
– Offset by cost of risk capital
• Option to move from RPI to CPI in future
– In anticipation of CPI market opening up in future
– Part refund of premium
– To whom – scheme or company
– On a buy-in or buy-out?
• Differential pricing?
24© 2010 The Actuarial Profession  www.actuaries.org.uk

26. But general market movements more significant
25© 2010 The Actuarial Profession  www.actuaries.org.uk
• Affordability chart reflects approximate asset/liability mix of
the Scheme (c70% equities and 80% non-pensioners)
• Chart assumes scheme is fully funded initially – for an
underfunded scheme the volatility in the deficit will be much
larger

27. Our survey says...
© 2010 The Actuarial Profession  www.actuaries.org.uk

28. Survey Results
Audience
1. What proportion of inflation-linked liabilities are matched
with inflation hedging assets such as index-linked gilts,
inflation swaps or buy-in insurance policies:
27© 2010 The Actuarial Profession  www.actuaries.org.uk
16 participants
0%
10%
20%
30%
40%
50%
60%
70%
0% - 25% 25% - 50% 50% - 75% 75% - 100%
Proportion of matching assets

29. Survey Results
Nationwide
1. What proportion of inflation-linked liabilities are matched
with inflation hedging assets such as index-linked gilts,
inflation swaps or buy-in insurance policies:
28© 2010 The Actuarial Profession  www.actuaries.org.uk
88 Actuaries, 19 Trustees
0%
10%
20%
30%
40%
50%
60%
70%
0% - 25% 25% - 50% 50% - 75% 75% - 100%
Proportion of matching assets
Actuaries Trustees

30. Survey Results
Audience
2. Broadly what proportion specify statutory minimum
revaluation/indexation, i.e. they could automatically move
to CPI:
29© 2010 The Actuarial Profession  www.actuaries.org.uk
16 participants
0%
10%
20%
30%
40%
50%
60%
70%
80%
<25% 25% - 50% 50%-75% >75%
"Statutory minimum" specified
Revaluation in deferment Benefit indexation in payment

31. Survey Results
Audience
3. For those that could automatically move to CPI, will those
Schemes move to CPI (rather than retain RPI):
30© 2010 The Actuarial Profession  www.actuaries.org.uk
16 participants
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Yes No
Proportion of schemes
Yes No

32. Survey Results
Audience
4. In your view is it fair that schemes that can move to CPI
should move to CPI?
31© 2010 The Actuarial Profession  www.actuaries.org.uk
15 participants
Yes
67%
No
33%

33. Survey Results
Nationwide
4. In your view is it fair that schemes that can move to CPI
should move to CPI?
32© 2010 The Actuarial Profession  www.actuaries.org.uk
70 Actuaries, 19 Trustees
0%
10%
20%
30%
40%
50%
60%
70%
80%
Yes No
Actuaries
Trustees

34. Survey Results
Audience
5. What is your long term expectation for CPI inflation
relative to RPI inflation:
33© 2010 The Actuarial Profession  www.actuaries.org.uk
16 participants
0% 10% 20% 30% 40% 50% 60% 70% 80%
Same as RPI
c.0.5% p.a. less than RPI
c.0.5% to 1% p.a. less than RPI
1% to 2% less than RPI

35. Survey Results
Nationwide
5. What is your long term expectation for CPI inflation
relative to RPI inflation:
34© 2010 The Actuarial Profession  www.actuaries.org.uk
89 Actuaries, 19 Trustees
0% 10% 20% 30% 40% 50% 60% 70% 80%
Same as RPI
c.0.5% p.a. less than RPI
c.0.5% to 1% p.a. less than RPI
1% to 2% less than RPI
Actuaries Trustees

36. Survey Results
Audience
6. Of possible de-risking options, which of the following do
you think your schemes consider seriously over the next
3 years:
35© 2010 The Actuarial Profession  www.actuaries.org.uk
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Buy-in or buy-out Longevity swap Liability
Management
exercise
None Other
Unlikely Likely Almost certainly

37. Survey Results
Nationwide
6. Of possible de-risking options, which of the following do
you think your schemes consider seriously over the next
3 years:
36© 2010 The Actuarial Profession  www.actuaries.org.uk
87 Actuaries, 18 Trustees
0%
10%
20%
30%
40%
50%
60%
Unlikely Likely Almost certainly
Liability Management Exercise
Actuaries
Trustees

38. Survey Results
Nationwide
6. Of possible de-risking options, which of the following do
you think your schemes consider seriously over the next
3 years:
37© 2010 The Actuarial Profession  www.actuaries.org.uk
86 Actuaries, 13 Trustees
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Unlikely Likely Almost certainly
Longevity Swap
Actuaries
Trustees

39. Survey Results
Nationwide
6. Of possible de-risking options, which of the following do
you think your schemes consider seriously over the next
3 years:
38© 2010 The Actuarial Profession  www.actuaries.org.uk
87 Actuaries, 19 Trustees
0%
10%
20%
30%
40%
50%
60%
70%
Unlikely Likely Almost certainly
Buy-in/Buy-out
Actuaries
Trustees

40. Survey Results
39© 2010 The Actuarial Profession  www.actuaries.org.uk
6. Other:
“More direct investment in gilts rather than swaps”
National responses
“Journey planning / flight path / de-risking triggers”
“Phased buy-in, via annuity purchase when members retire”
“Closing to future accrual (for those few schemes still open)”
“Increase in LDI assets”
“Winding up”
“More bonds”

41. Survey Results
40© 2010 The Actuarial Profession  www.actuaries.org.uk
7. What impact has the CPI move had on schemes
considering de-risking?
“Little / None”
“Potential reduction in Buy-out cost. Slightly more scope to exchange
pension increases. Some offset CPI gains through lower risk investment
strategy”
“Caused delays to some looking at buy-in/out because insurers have
been unable to provide CPI pricing”
“As far as I am aware [public sector schemes] are not looking to derisk,
other than via wholesale benefit changes following Huttons report”

42. Questions or comments?
41© 2010 The Actuarial Profession  www.actuaries.org.uk
Jay Shah
• Co-Head of Business Origination
• Pension Corporation
• shahj@pensioncorporation.com
• Tel: + 44 20 7105 2111
Robert Gardner
• Co-Chief Executive
• Redington
• robert.gardner@redington.co.uk
• Tel: + 44 20 7250 3416
 In addition...
 http://twitter.com/robertjgardner
 http://uk.linkedin.com/in/robertjgardner