With the start of the consultation for proposed changes to the measurement of inflation in the UK, we look at the likely impact to asset classes, the assets most affected, and the key issues investors should be aware of.
9 minute read
The UK Statistics Authority has long considered the Retail Price Index (RPI) to be a flawed measure of inflation and pushed for it to be retired for some time.
In September last year, then Chancellor of the Exchequer, Sajid Javid, wrote to Sir David Nosgrove, Chair of UK Statistics Authority, and confirmed a public consultation would be held on the implementation of proposed changes to RPI, with a specific focus on aligning it to the Consumer Price Index including Housing costs (CPIH).
The public consultation opened on 11 March. In a nutshell, the proposition is to calculate the RPI index values using the same methods and data sources used for CPIH. This means RPI would continue to be published but, from the implementation date onward, its growth rate would be the same as the CPIH growth rate (monthly and annual). In addition, RPI sub-indices would no longer be published.
The public consultation questions – which are much broader than the narrow question of when a change should be implemented – address the proposed methodology, timeframe, and potential impacts on index-linked gilts and other asset classes.
In this Q&A, we set out our views on what this could mean for investors.
Who is affected, and which assets are impacted by the proposed changes?
The effects will be felt across a broad group:
- Investment saving products used by individual investors:
- RPI-linked pensions and annuities
- Public assets owned by both individual and institutional investors:
- Index-linked gilts
- RPI Inflation swaps
- RPI-linked corporate bonds
- Real assets owned by both individual and institutional investors:
- Long-lease real estate
- Ground rents
- Infrastructure assets with RPI-indexed revenues or costs
- RPI-linked private debt (across infrastructure and corporate borrowers)
Pensioners, including individuals who have purchased an RPI-linked annuity, could receive a lower income than previously expected. In addition, rail travellers, holders of student loans and a host of other services with prices tied to inflation could be affected.
Pension schemes and insurance companies will be impacted through the assets they hold to match liabilities. While their RPI-linked liabilities would go down in parallel with RPI-linked assets, many schemes and insurers also hold CPI-linked liabilities that are hedged through RPI-linked assets because of the limited availability of CPI-linked assets. In these instances, the assets would likely fall in value without an offsetting fall in the liabilities.
What does this mean for public assets?
The overall pool of affected assets is extremely large. Asset values could be negatively affected, as the value of future cash flows will be reduced if a different calculation leads to a lower RPI. The extent of the impact will vary depending on the level of inflation linkage provided by the asset.
On the public markets side, £670 billion of index-linked gilts are currently due to mature after 2025 (£570 billion of which will mature after 2030) and could be impacted. In addition, the RPI inflation swap market could be impacted.
Around £60 billion of the notional value of the UK’s listed indexed-linked corporate bonds could be affected (source: Bloomberg, Aviva Investors). As some of these bonds will mature beyond 2060, we estimate the loss potential could exceed £6 billion (assuming RPI is replaced by CPIH in 2030 without any compensation and CPIH remains constant at 1.5 per cent).
While new issuance of index-linked gilts and corporate credit so far continues to be linked to RPI, once the government makes a decision, asset holders may not be able to change these contracts. However, they can lobby for an appropriate replacement during the consultation period, and possibly claim compensation from the government on gilts if an acceptable alternative is not found.
What will the impact be for private markets?
We expect a range of private assets to be impacted, including long-lease real estate, ground rents, infrastructure assets with RPI-indexed revenues or costs, and RPI-linked private debt (across infrastructure and corporate borrowers).
Long-lease real estate and ground rents
Within long-income real estate, most existing lease contracts provide for the adoption of a replacement index in the event RPI is abolished. Should the government not offer an alternative reference, most contracts state it can be determined either by agreement between the parties or by an expert if the parties cannot agree. However, provisions for bilateral or expert determination could lead to different outcomes for different contracts, with no guarantee investors won’t be left worse off.
There is generally even less protection in existing leases if RPI continues to be published but a material change in methodology results in it being at a lower than expected level, which would be the result of the proposal to harmonise its calculation with CPIH. In this case, investors in RPI-linked long-income leases may experience a significant reduction in value.
There are also a small minority of leases linked to RPIX, which as a sub-index would no longer be published under the proposal.
We are engaging with valuers and our peers to see if any changes are taking place across the market. Investors are reviewing their existing leases to understand the potential impact. As yet, there is no common approach to addressing the potential change going forward, either in long-lease real estate or ground rents. In particular, no alternative index is commonly used.
If there is a change, we expect the impact on our clients’ investments could be minimised through the adoption of a “CPIH/CPI + x%” method,1 where “x” is determined to ensure the outcome is economically the same as under an existing RPI contract. For new lease terms, a clause allowing us to switch to an alternative index of “CPIH + x%” could be explored, aiming to compensate for the loss of asset value in the event of a material change to RPI that makes it unfit for purpose.
After several years of growth, the RPI-indexed long-income market is about £40 billion today, according to CBRE. While smaller than the indexed-linked gilt market, it is nevertheless exposed due to the long duration of assets. If not offset by a CPIH + x% adjustment, we estimate the change could result in a loss of value of up to 20 per cent for long-income assets, depending on their duration – and £2 billion to £4 billion in aggregate over all sectors.
Infrastructure assets are generally perceived as good inflation hedges. Some, including regulated utilities, private finance initiative (PFI) contracts and most renewable assets, can benefit from explicit inflation indexation (historically based on RPI) in their revenues. For utilities, regulators have already reflected the change to the inflation measure by moving away from RPI to CPIH for future regulatory periods for water and electricity. While this is due to be implemented in a neutral way, companies that have issued RPI-indexed long-term debt could be negatively impacted.
Also affected will be PFI contracts and renewable projects benefitting from feed-in-tariff (FiT) or renewable obligation certificates (ROC) revenues indexed on RPI. Without proactive government action, these projects could see revenues fall if the inflation calculation is amended. Because many projects are highly leveraged, lower cash flows linked to a lower inflation measure may cause credit stress, particularly towards the end of their life. Overall, the market is likely to see a progressive loss in value as most market participants still rely on RPI to project cash flows and assess the value of assets.
We estimate the £68 billion index-linked private corporate debt market could see a reduction in future income of between £3 billion and £6 billion over the life of the debt. For infrastructure, we estimate £837 billion of future payments could be affected (this estimate is focused on FiTs, ROCs, renewable heat incentives and PFI credits). The impact could be a reduction in future income of between £3.5 billion and £8.5 billion.2 Overall, the impact on private markets could exceed £10 billion – with a corresponding detriment on the holders of these assets, including pension funds.
What are the key points to be aware of in the consultation?
Although the initial market reaction has been muted as the consultation is not top of mind for most investors given concerns over Covid-19, the proposals set out are significant.
The full paper is detailed, and we will be developing our analysis and thoughts over the coming weeks as we prepare our response. What is already obvious is that, if it were implemented, the methodology change to align RPI calculations to CPIH would result in the loss of the current ‘wedge’, around one per cent per annum.
This means pensioners receiving an RPI-linked pension, investors in RPI-linked gilts and private assets, and pension funds and insurers using RPI-linked assets to match liabilities could be worse off. As an index user, they paid for a level of uplift that the change would lower unilaterally.
Although the consultation paper states the Chancellor cannot take issues into account beyond the impact on gilts, “they may be relevant in wider policy contexts”. This may lead to any number of decisions, and we will therefore use the consultation to advocate for RPI-linked assets to use ‘RPI + 1%’ as the reference growth rate if the change comes into force.
While the government is more limited in terms of enforcing changes to private contracts, it should nonetheless provide guidance on how references to RPI should be amended, particularly given the number of contracts that may go into arbitration if and when the change goes ahead.
Adding the extra percentage point to RPI after the methodology change is the fairest way to make it more robust statistically, whilst not negatively impacting pensioners and investors. Questions 4, 5 and 6 in particular (listed below) give us the chance to:
- Lay out the potential impact on pensioners and other index users;
- Quantify and analyse the potential impact on assets beyond the gilt market;
- Express our concern that investors’ justified expectations of returns on these assets may not be borne out, and that they should be properly compensated.
With these questions now released, it is important stakeholders respond to ensure the changes are fair to all users of RPI.
Public consultation questions:
- Do you agree that this proposed approach is statistically rigorous?
- What will be the impact on the interests of holders of ‘relevant’ index-linked gilts (i.e. 2½% IL 2020, 2½% IL 2024 and 4 1/8% IL 2030) of addressing the shortcomings of the RPI in a) 2025 b) 2030 or c) any year in between?
- What will be the impact on the interests of holders of all other index-linked gilts of addressing the shortcomings of the RPI in a) 2025 b) 2030 or c) any year in between?
- What will be the impact on the index-linked gilt market or those dependent on it of addressing the shortcomings of the RPI in a) 2025 b) 2030 or c) any year in between?
- What other impacts might the proposed changes to address the shortcomings of the RPI have in areas or contracts where the RPI is used?
- Are there any other issues relevant to the proposal the Authority is minded to make of which the Authority or the Chancellor ought to be aware?
- Which lower level or supplementary RPI indices are currently used, and what are they used for?
- What guidance would users of lower level or supplementary RPI indices find most useful for the ONS to provide?