The Government was due to formally respond to this report in the spring. Needless to say, other more pressing matters came up and the response was bumped not once but twice. Finally, third time lucky, we have had the formal response from Sajid Javid on 4 September. Consistent with our own view that this can only be a slow burn topic, the Chancellor has confirmed that there will be no change before 2025 and the Government will publicly consult on whether to make any changes before 2030, and if so when between 2025 and 2030. The consultation will include looking at how to align RPI with CPIH, suggesting that CPIH remains on pole position as the preferred inflation measure. In fact, the Chancellor explicitly states that it is the Government’s objective that CPIH becomes its headline measure of inflation over time, whilst reviewing its use of RPI at future fiscal events.
This consultation will begin in 2020 with a response promised before the Spring Statement and end of the financial year.
A further important statement in the Chancellor’s response is that “the Government has no current plans to stop issuing gilts linked to RPI.”
However, one fly in the ointment is that beyond 2030, the Chancellor is not required to approve changes to the inflation index underpinning index-linked gilts and the UK Statistics Authority has expressed a clear preference for aligning RPI with CPIH at this point. This being despite clear advice from the Bank of England that such a move would be “fundamental and materially detrimental.” There are likely to be some practical and legal obstacles to such a change, but the news has caused a re-pricing of long-dated index-linked gilts and, until further clarity is available, this is likely to impair liquidity and increase volatility in the index-linked gilt market.
What this means for LDI clients
As we have previously suggested, this announcement confirms that there will be no short-term change to RPI and therefore no immediate impact to pension schemes. Given the significant exposure that many schemes have to RPI it remains an important topic but one that can be monitored and understood over the coming years. It was reassuring to read in the Chancellor’s response that he acknowledges that stakeholders will need substantial time to prepare for any changes.
To the extent that pension schemes are hedging RPI-linked liabilities any move in index-linked gilt pricing or a future alignment of RPI with CPIH will be matched on both the asset and liability side of the equation.
Where schemes are using RPI-linked assets to hedge CPI-linked liabilities, any price move or subsequent change to RPI is detrimental. However, for most pension schemes, CPI linkages only apply in deferment and are therefore a minority portion of liabilities and are relatively short-dated, with most falling away over the next 10 years. The extended timeframe for any possible changes means that this has therefore become an even smaller issue for many schemes.
The increasing use of CPI and CPIH as a measure of inflation has resulted in an increase in CPI issuance from corporates, which in turn feeds through to the swap market. To be crystal clear; the CPI market remains very small and illiquid compared to the RPI market and asset purchases need to be made opportunistically. However, for schemes with meaningful levels of CPI-linked liabilities that are currently hedged with RPI-linked asset there is increasing scope to pick up CPI-linked assets opportunistically and we expect this scope to increase over the coming years.
We recommend that schemes spend time understanding the level and nature of CPI and RPI sensitivity in their liabilities and work with their LDI manager to ensure that their hedging strategy is consistent with this. When doing this work, it is important not to discount the impact of any inflation caps and floors and our recent paper on this topic (view here) discusses some of these impacts.
Our current view is that the suggestion of aligning RPI with CPIH is unworkable, impractical and likely to give rise to a strong legal challenge but until further clarity arises the market is likely to continue to be volatile. Given this backdrop, we suggest that clients considering significant allocations to real yields and inflation hedging contact us first, so we can provide guidance as to the most cost-effective way to implement the desired hedging.