More drama from the Office of National Statistics (ONS) today, although it’s possible you missed it. Avid followers of these things will know that pension plans have, for the last couple of years, been in a sort of limbo as regards the two leading (but crucially different) measures of inflation: Retail Price Indexation (RPI) and Consumer Price Indexation (CPI).
Back in 2010, the government announced that it had had enough of RPI generally, and preferred CPI. Because the government is the government and can do what it likes, it also announced a wholesale switch from linking pension payments to RPI, to linking pension payments to CPI. This was pretty punchy stuff because RPI is usually higher than CPI and over the long term, pensioners could reasonably expect their pensions to fall significantly. Many, therefore, regarded the proposed switch as nothing more than a cynical ploy by the government to reduce its public sector pension liabilities. The govenment protested that this view was harsh and unfair, maintaining that it was simply concerned with consistency (it uses CPI for most inflation type calculations).
As my kids say, Whatever.
For those who thought that was the end of it, it wasn’t. Last October, the National Statistician announced a consultation into the differences between RPI and CPI, noting that these different measures of inflation were not helpful and probably not in line with international standards. Further, it became clear, her conclusions would potentially lead to the reduction or complete elimination of the differences between the two measures, with RPI, in effect, being modified to become CPI. This harmonisation of RPI with CPI was the National Statistician's “Option 4”.
The potential impact (of changing RPI into CPI) on the markets, on gilts and on pension benefits (which are linked to inflation) would be significant.
So here’s the punch line:
The market was fairly certain that The (Option 4) Change would be made and that RPI would henceforth become CPI. Here’s what one leading investment bank had to say a couple of days ago:
“Option 1 [no change] should be ruled out. The ONS's view is clear, the independent expert Diewert’s view is clear, and there doesn’t appear to be any way to fudge the result by doing something other than the maths differently.”
Thus, the market had “priced in” The (Option 4) Change as though it had already happened. Or rather it had priced in a lot of The (Option 4) Change, waiting until today for the full announcement.
Once The (Option 4) Change happened, all inflation linked instruments would get cheaper (due to RPI (which is higher) morphing into CPI (which is lower)). Lower inflation means cheaper index linked gilts and swaps.
Thus many pension funds stood on the side lines waiting for The (Option 4) Change to be officially announced, so that they could buy cheaper index linked gilts and inflation swaps following the switch.
Today is D-Day. Guess what? The (Option 4) Change didn’t happen after all.
The National Statistician, Jil Matheson went for …….. Option 1 (NO CHANGE)!
Here’s this morning’s ONS press release. See how Jil starts by teasing us with a gorgeous feint:
“Following a consultation on options for improving the Retail Prices Index (RPI), the National Statistician, Jil Matheson, has concluded that the formula used to produce the RPI does not meet international standards and recommended that a new index be published.”
But not so fast, amigo. Jil is leading us right up the garden path, as it turns out, for just two short paragraphs later…
“In developing her recommendations the National Statistician also noted that there is significant value to users in maintaining the continuity of the existing RPI’s long time series without major change, so that it may continue to be used for long-term indexation and for index-linked gilts and bonds in accordance with user expectations. Therefore, while the arithmetic formulation would not be chosen were ONS constructing a new price index, the National Statistician recommended that the formulae used at the elementary aggregate level in the RPI should remain unchanged.”
The markets, wrong-footed, gasped and reacted sharply. Read this nice piece by Dan Mikulskis.
It just goes to show. Trying to second-guess the markets, the Regulator, the Office of National Statistics, the Board of the UK Statistics Authority, the Bank of England, the Chancellor of the Exchequer, the Consumer Prices Advisory Committee, the Treasury, The Department of Work and Pensions, Jil or the Grand National, is a mug’s game.
Either you have a risk management framework for your pension fund or you don’t.