02 June 2016
What is your inflation rate?
by Frank O’Nomics
The government needs to find ways to make Tata Steel more attractive to potential buyers and one of the major hurdles to finding a buyer seems to be the deficit in the British Steel Pension Scheme, currently estimated at £700 million. As pension fund deficits go, this figure is relatively small, with that for the BT pension scheme forecast to rise from £6.4 billion to £10.6 billion when it undergoes its 3 yearly review next March (according to estimates by Macquarie). One of the proposals for making Tata Steel more attractive is to reduce the BS pension scheme deficit by changing the inflation measure used to calculate the liabilities from the Retail Price Index (RPI) to the Consumer Price Index (CPI). Because of differences in the constituents and the methodology behind these indices, there is, over the long run, a very big difference and the change could reduce the liabilities of the BS pension scheme by as much as £2.5 billion. The proposal (which is to be the subject of consultation) has received a great deal of condemnation because, as former minister Steve Webb has said, “it goes against the fundamental principle that pension rights already built up must be honoured”. However, it might also be argued that pensions should be indexed to the measure most appropriate to the underlying pensioners and, if changing the measure means that the rights for most pensioners are better than having their pensions taken over by the Pension Protection Fund, then such a change makes good sense.
Most people probably think that RPI and CPI are the same thing, and that is not an unreasonable assumption, with the latter measure replacing the former for the calculation of increases in benefits, tax credits and public service pension in 2010. CPI is much more in line with calculations of inflation in the rest of Europe and the switch effectively saved the government a great deal of money because, due to the exclusion of most housing related costs and the fact that it uses a geometric (rather than arithmetic) mean for the calculation of prices, it produces an inflation rate generally around 1% lower than RPI. 1% does not sound much but if you look at the difference this makes over the course of a lifetime you get a very significant number – hence the £2.5 billion that would be knocked off the liabilities of the £14 billion BS pension scheme.
Ultimately what matters in deciding whether you get effective protection from the ravages of inflation is entirely dependent on your personal circumstances. If you are paying a mortgage (most pensioners won’t be), or are someone who moves house regularly (again most pensioners will not), then RPI might be a more appropriate measure, but there are other items included in CPI which are not taken into account in RPI, such as student accommodation and some investment fees which may be much more applicable to the population in general. The very low inflation rates for food and clothing as well as energy (due to a significant fall in the oil price) will mean that those who spend an above average proportion of their income on these will recently have had a very low personal inflation rate, whereas a student who experienced the quantum leap in university fees a few years ago, and has been seeing very high increase in accommodation costs, will have a particularly high one. Finding an up-to-date website which allows you to put in your personal circumstances to see what inflation rate is applicable to you is not easy, but the range of values for different circumstances is likely to be widely different. The point is that the choice of the right inflation measure for a pension scheme is not easy, but, if one can argue that CPI is closer to the right measure than RPI, there is a justification for making the change. This justification becomes stronger if it means that companies have to contribute less to cover their pension deficits – very important for the future of our economic prosperity as this money could be used to invest for growth, or given to shareholders and/or employees, who would then save (invest) or spend it.
The current consultation is only to consider the Tata Steel situation as a special case. Those concerned about the potential impact if the use of CPI was applied to all pension schemes have come up with a number of £200 billion in lost retirement incomes. This is clearly significant, but not unfair if you look at the adjustment as a way of removing an overpayment to pensioners due to the use of an inappropriate measure. Further, if a general shift to CPI occurred it would significantly decrease the likelihood of companies defaulting on their pensions and having to resort to the Pension Protection Fund. When the PPF becomes involved, the fall in pensioners incomes is likely to be much greater than that resulting from a measurement change (at least for most pensioners – a small number of participants in the British Steel scheme may be better off going to the PPF due to the terms of their contract). It is important to remember just how serious the level of pension fund deficits is in aggregate: of the 6,000 private defined pension schemes in existence, 5,000 are in deficit which cumulatively is currently around £805 billion, versus a surplus of just £4 billion in the other funds. Instead of lost retirement incomes it might be more forward thinking to look at the £200 billion as money that could be invested in our future prosperity.
It is very easy for someone in a defined contribution scheme to advocate changing the inflation measurement used for defined benefit schemes as he or she will suffer no impact. Also the change may not be a vote winner given the number of pensioners who would protest at the impact on their future income. However, those on defined benefit schemes, almost all of which are now closed, have a significantly better deal, and the proposed changes will generally just moderate that advantage. There is of course a significant and very reasonable question concerning the cutting of pensioners’ benefits without their consent, which sets a dangerous precedent.
The Chair of the Work and Pensions Committee, Frank Field, has said that “we must ensure that a laudable attempt to save steel jobs doesn’t inadvertently undermine the pensions of millions across British industry”, and it is quite right that a thorough consultation process takes place. Still, there is an opportunity to reduce a very expensive corporate legacy.
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