Update 2 – FCA Guidance FG17/9 “Guidance for firms on how to calculate redress for unsuitable defined benefit pension transfers”
In our first update on this subject, we said “Somewhat paradoxically, given that the reform is to the RPI methodology, the FCA change is likely to be limited to how CPI is to be forecast” (although we would have to wait to see what FCA say in their announcement in mid-March).
Several people have asked us to explain why this is.
The FCA guidance requires future inflation (for the period to the end of life of current and deferred pensioners affected) to be estimated from the Bank of England “implied inflation forward curve (gilts)”. That curve (a set of rates for different future periods extending into the far future – rates are published up to 40 years and can be extrapolated beyond that) is derived from actual prices in index-linked gilts. Those gilts are RPI based but there is an active market and therefore current and forward prices are readily known which translates to known values for current (and market expectation of) future RPI.
The first point that has to be recognised is that those buyers and sellers of index linked gilts know that the calculation of the RPI measure is changing in 2030. The prices at which they will trade in index linked gilts has changed accordingly – we say that the market has “priced in” the change
The second point is that there is sufficient detail of the change to be made in 2030 to know that the methodology for calculating RPI – which is what is being changed – will be much closer to the methodology for calculating CPI – it is actually CPIH (CPI including housing costs).
The third point is to recognise that forecasts of CPI will therefore need to be closer to forecasts of RPI (or CPIH as of 2030) than was the case previously. The current FCA basis for forecasts of CPI, as the forecast for RPI less 1% per annum, is no longer valid – the margin will have to be smaller but possibly not zero as there is a difference between CPI and CPIH.
What this means in practice is that valuation of pension benefits subject to adjustment by CPI will be higher – possibly significantly higher – but that depends very much of the pension characteristics e.g., longevity of the member etc.
