In April 2011, the price index used to index most items of government expenditure (tax credits, benefits, public service pensions) was changed to the Consumer Prices Index (or CPI), whereas previously the Retail Prices Index (RPI) had been used. Also most of those private scheme pensions which had indexation rules referring the Pensions Increases Act 1971 were required to make the change.
The main differences between the CPI and RPI are:
the RPI includes some housing costs (house prices and mortgage and council tax payments) that are excluded from the CPI,
the RPI is calculated using arithmetic means while the CPI uses geometric means to form the price indexes which is often called the "formula effect".
To enlarge the right hand part of the graph hover your cursor over that part and click (and again if required). To restore click the "Zoom Out" button, top right or your reload button on your browser.
As can be see above the CPI inflation rate tends to be lower than the corresponding RPI inflation rate. This reflects the tendency for housing costs to increase more rapidly in comparison to the costs of other goods and services and also the fact that mathematically the geometric mean has to be less than or equal to the arithmetic mean for a given set of prices.
Thus using the lower CPI measure of inflation to increase the money value of benefits and pensions therefore has the effect of eroding the value of benefits and pensions in real terms. The result of increasing tax thresholds using the CPI is to slowly push more and more people into higher tax brackets – a process economists term as “fiscal drag”.
The percentage differences between the CPI and RPI may appear to be small but they accumulate over time and can amount to significant amounts of money. For example, assuming an RPI of 3% and a CPI of 2.33% per annum over a retirement duration of 25 years, the change from RPI to CPI reduces the value of a pension having an initial value of £10,000 pa by approximately £30,000.
The RPI remains in use, however, to index many items that raise government revenue such as fuel duty and alcohol and tobacco taxes and it is also used to index student loan repayments.
Thus by making this indexation change the government maintains its income whilst minimising its expenditure. The real reason for making the switch was secure cuts in all welfare payments to reduce the deficit. However for occupational pensions the government claimed that main reason for the change is that the CPI is the "more appropriate” index for pensions on the grounds that it does not include mortgage interest payments and 70% of pensioners do not have mortgages. However the CPI excludes all owner occupier housing costs which for most pensioners constitute a major item of expenditure. Furthermore considering that pensioner inflation is recognised as being higher than RPI anyway it is clearly punitive to select the lower of the two indices.
For a more detailed picture of the various components which make up the inflation indices click here.This is a user friendly website operated by Simon Briscoe, a member of the Royal Statistical Society and a former assistant editor of the Financial Times. By clicking on anywhere towards the right hand side of the charts one can isolate the stats for the last few years. It may be best to isolate the time range from 2009 onwards to isolate the recent data and avoid the anomalous data arising from the negative inflation before that period. The data is automatically updated monthly.
For a more detailed account of the switch see the following excellent articles:
