Very Nice Advice

So you may have noticed that there’s lots of news at the moment about schemes and funds and index-linked whatnots changing their measure from RPI to CPI, not least because of this announcement in the 22 June 2010 Budget: 

The Government will adopt the CPI [replacing the RPI] for the indexation of benefits, tax credits and public service pensions from April 2011. 

 But what does this really mean? Both the RPI and CPI measure inflation: ie how much the prices of things we buy have gone up (or down, in the case of deflation), over a period of time. This inflation figure is important because it enables us to tell how much our money is worth.

We all appreciate that if we lived in 1610 and were given £100, we’d probably feel a lot richer than if someone gave us £100 in 2010 (though don’t let that stop any donations…). In fact this MeasuringWorth website allows us to tell what £100 in 1610 would be worth in today’s money … and the answer is … somewhere between £15,300 and £199,000. The first figure is assuming that £100 grew each year by the Retail Price Index (RPI), and the second by the rate of our “average earnings”. And that in itself shows that while the prices of the things we buy have gone up a lot over the years, in actual fact the amount we earn has increased by much more. So we are, generally, wealthier. Than we were 400 years ago. That’s a relief.    

But back to RPI vs CPI. The Retail Prices Index is probably the most familiar measure of inflation, and it’s calculated on a monthly basis by some diligent bods checking the prices of about 650 items that broadly represent what we would ordinarily spend our money on – our ‘basket of goods’ - everything from bread, coffee, wine, cigarettes, biscuits and cakes (thank you), to rent, gas bills, clothes, music, holidays and petrol. These average prices are then compared to previous ones to see how much prices have changed over a period of time, and so how much extra money we need to buy the same things today that we did, say, a year ago.    

So if your pension payments are ‘index-linked’ and increase each year by the RPI figure, that means it’s just ensuring that you can afford to buy the same things today that you could afford to buy last year. For those people who receive level pension payments, rather than index-linked, over time you should find that things feel less affordable, as prices continue to rise but your income stays the same.    

The Consumer Prices Index (CPI) is actually pretty similar to the RPI: it also measures changes in the prices of goods. But there are differences (otherwise what would all the hoohah be about):   

• Things that are counted in the RPI but not the CPI: Mortgage interest payments, depreciation, council tax & rates, dwelling insurance and ground rent, vehicle tax. The inclusion of mortgage costs means that when interest rates reduce, the RPI often comes down, as people are paying less on their mortgage than they were before.
• Things that are counted in the CPI but not the RPI: unit trusts and stockbroking charges, foreign students’ university tuition fees and university accommodation fees. Because mortgage and council tax costs aren’t included,  people’s costs of living can increase dramatically, without it affecting the CPI.
• The RPI is based on the spend of typical households in the UK, excluding the very poor and the very rich, whereas the CPI considers the typical spend of all households, including foreign visitors, and halls of residence, nursing homes etc
• Goods and services are classified differently between the two, which means that the weightings are different
• And, pretty importantly:

The mathematical formulae used to calculate the changes for the most detailed components of the two indices [are different]. In practice this means that the CPI always shows a lower inflation rate than the RPI for given price data. 

The CPI is also the measure used by the Bank of England as its inflation target; so the Bank aims to ‘manage’ inflation (through changing interest rates, which impact on prices) to keep inflation as close as possible to 2%/year. It’s currently at 3.4%, which means the Governor of the Bank has to write to the Chancellor of the Exchequer explaining what’s gone wrong and what he plans to do about it (he’s very welcome to that job, I can tell you). 

So in short, if your income – or benefits – are now tied to the CPI instead of the RPI, they’re likely to increase at a slower rate than before, because they’re calculated slightly differently, and because the CPI ignores the cost of mortgages.

The government, who are of course doing this to reduce their costs, argue that this shouldn’t matter too much as the people most likely to be affected by the change (those on benefits, and pensioners) are less likely to have mortgages – and so there isn’t any great need to ensure their income keeps pace with mortgage costs. There can also be benefits: the chart on the right shows how the RPI figure fell below zero last year, whereas the CPI was less volatile: only a good thing.

Of more concern to me, I think, is the legitimacy of changing the terms of a pension contract, particularly where the pensions are already in payment. But that’s another story…

For more info take a look at a brief guide to Consumer Price Indices (opens a PDF) from the Office for National Statistics.