As CPI replaces RPI as a measure of inflation, what impact could it have on your finances?
It has probably not escaped your notice that in the June 2010 Budget, the measure used by the Government to increase state benefits for the effects of inflation from April 2011 onwards is to be the Consumer Prices Index (CPI) rather than the Retail Prices Index (RPI). This change will also affect adjustments to public sector pensions.
But what is the difference between the two measures, and what could the compound effect be?
CPI vs RPI
The CPI and RPI are based on a basket of goods and the changes in the cost of that basket form the basis for the indicies. It is a larger than average shopping basket though, containing about 650 representative items.
Each year, the basket is reviewed and items may be added, removed or replaced to accurately reflect the buying habits of the UK population. Blu-Ray DVD players are new in the basket for 2010, and hair straighteners and lip gloss replace hairdryers and lipstick, in case you were wondering.
However, the main difference between the two measures is the inclusion of housing costs in the RPI. These costs can include mortgage interest, rent, council tax and other similar items.
As a result, changes in interest rates will affect the RPI. So, if rates are cut, the RPI will fall but not the CPI. The CPI also includes some financial services not included in the RPI and is based on a wider sample of the population for working out relative weightings.
RPIX and RPIY
RPIX is the same as RPI minus mortgage interest payments and is therefore is closer to CPI although not exactly same. RPIY measures core inflation, by further adjusting RPIX to remove the effect of indirect taxes such as VAT and excise duty.
By way of example, the forthcoming VAT increase will 'artificially' increase both RPI and RPIX but not RPIY.
What's the difference?
Traditionally, the CPI is lower than the RPI, which is probably why the Government use it for the inflationary targets imposed on the Bank of England, and why changing from RPI to CPI will save an estimated £6 billion a year by the end of this parliamentary term.
However, where interest rates are falling, as in 2009, RPI may actually be lower than CPI owing to falling mortgage interest payments.
Over the past ten years, the comparative annual percentage changes in both indices are as follows. I've used the September value, as this figure is used for tax and benefit purposes.
| Year | RPI | CPI |
|---|
| 2000 | 3.3 | 1.0 |
| 2001 | 1.7 | 1.3 |
| 2002 | 1.7 | 1.0 |
| 2003 | 2.8 | 1.4 |
| 2004 | 3.1 | 1.1 |
| 2005 | 2.7 | 2.5 |
| 2006 | 3.6 | 2.4 |
| 2007 | 3.9 | 1.8 |
| 2008 | 5.0 | 5.2 |
| 2009 | -1.4 | 1.1 |
The compound effect over this ten-year period is that using RPI would give a 30% increase but the CPI only 20%.
The issue is magnified over longer periods of time, as you would expect. CPI data for the UK only goes back to 1988 but, since that time, this measure of inflation has risen 84%, whereas RPI is up 125%. In terms of average annual increases, that's about 2.8% for CPI and 3.8% for RPI.
For example, assume you have contributed to a public sector scheme. Say the CPI averages 1% less than the RPI, as it has done in the past, and you get a starting pension of £10,000.
If CPI runs at 2.8% a year, after 10 years your pension would have risen to £13,200. Using RPI of 3.8% though, it would have increased to £14,500.
CPI increases may also apply to any private sector pension you have. However, most private schemes apparently have RPI increases written into their trust deeds, so will be unaffected by this change.
Due to the pressure on public spending, many people would argue that this change is a necessary evil. But it does mean that many of us will have put more aside than we previously thought, if we want to ensure a decent retirement income.
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