Inflation – RPI versus CPI
You never know if anyone reads the articles you write - or has any interest in their content. So it was nice to receive an email from a reader after the last article. For those of you who didn’t read it, the article was about occupational pension schemes and the inherent benefits they offer.
To illustrate the point, I used the example of an occupational scheme that offered an income linked to RPI. The informed reader pointed out that I hadn’t made it clear that not all occupational schemes were linked to RPI. Many are linked to CPI and those two measurements can be very different and can make a significant difference to the income received over the long term. It was a valid point so I thought it would be helpful to explain the difference between the two and why it is important.
RPI, or the Retail Price Index, and CPI, the Consumer Price Index, are measurements of inflation. Measuring inflation is important as it tells us whether prices are going up or down, and to do so analysts compile a basket of goods and services we commonly use and track the combined movement in their prices.
The problem is RPI and CPI track slightly different things. For example, within RPI we have the cost of housing – mortgage interest cost and council tax – whereas those things are not included in CPI. However, they are also measured differently.
RPI is measured as a simple arithmetic mean, where the prices of everything are simply added together and divided by the number of items. CPI is measured using a geometric mean which is far more complicated, but arguably more accurate.
Importantly, the result is CPI is almost always lower than RPI, potentially by as much as 1% per year. Little wonder then that the Government links the payments it makes, such as the state pension, to CPI, while the income it receives, such as taxes, are linked to RPI.
Going back to your pension income, anything that is linked to inflation is important. But it is also crucial to know if it is linked to CPI or RPI. A difference of 1% per year may not sound like much, but over a payment period of 20 years or more, the effect of compound interest can make a significant difference to your real income in retirement.
Craig Davidson
Davidsons IFA