The government has confirmed plans to link private sector pension increases to CPI rather than RPI.
While this saves a significant amount of money - around £100bn by some estimates - there are wider implications, and such a move should be approached with caution.
First, it is important to ensure that pensioners in insured and self-administered schemes are treated equally.
Self-administered pension schemes pay pensions direct to members, whilst insured schemes secure members benefits by purchasing annuities. If self-administered schemes were allowed to move to CPI increases whilst the terms of annuities were left unchanged, then annuitants would receive higher pension increases than members of self-administered schemes; however, if the terms of annuities were also changed, then insurance companies could pocket a one-off windfall in respect of the lower expected increases. What would happen to such an increase? Would it be paid back to the pension scheme (which may no longer exist)? Would it go to the government? Or the shareholders? And would annuitants whose benefits had accrued in a defined contribution scheme be treated differently from those from a defined benefit arrangement?
Another issue for both pension schemes and insurance companies is that it is harder to find matching investments for CPI-linked benefits.
Index-linked gilts have payments linked to RPI, which can be used to match RPI-linked benefits. However, a pension scheme paying CPI-linked benefits would not be able to match benefits as closely using index-linked gilts - and an insurance company might be forced to hold larger reserves to allow for the mismatch.
This could have the perverse effect of offsetting the reduced cost of the benefits by requiring a higher price to be charged to compensate for the mismatch risks. How about using CPI-linked swaps instead? Well, banks need to hedge their risk as well, and whilst some of their inflation is sourced from firms with inflation-linked incomes (supermarkets being the classic example), much of the risk is hedged using index-linked gilts. This could mean banks charging a higher margin on swaps, so the mismatch risk - and cost - is still there. Ultimately the government might have to start replacing its RPI-linked gilts with CPI-linked versions - it would be interesting to see how the gilt markets reacted.
Whilst moving from RPI to CPI for pension increases could save a lot of money - for pension schemes as well as the Government - there are a range of issues that need to be ironed out.
Paul Sweeting is professor of actuarial science at the University of Kent
This article was orginally published on his Blog: http://blog.paulsweeting.com/
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