Index-Linked Gilts question

masonic

It's arguable that the arithmetic mean used in RPI really was problematic and CPIH is a better measure. The change could have been made without a sustained raid if the market priced in a premium for the longer duration varieties and demanded a lower price for future auctions. But that doesn't appear to have happened. Instead, we're in a situation where inflation has to be over 1% above target just to break even. There have been long periods of time where this wouldn't be the case. For example, someone index linking for 30 years in 1992 would have had an annualised uplift of 2.8% based on RPI, which might have cost them a little vs not index linking, but if indexed on a CPIH basis would have left them around 30% worse off again. So that is the sort of thing to be factored in when considering including ILG within your bond investments as a private investor.

On the retirement income side, it makes the decision between RPI-linked and flat 3% escalation annuities more difficult than it was, since there is about a 0.4%pa cost to the former over the latter, which will mount up. Essentially, CPIH will need to be sustained at more than 3.4% (1.4% above target) for the cost to be worth it.

GeoffTF

aroominyork said:

You have an option whether to buy ILGs - you do not have to 'put up with it', unlike income tax which is pretty much unavoidable. 

People buy the ILGs to avoid income tax. There are no 0.125% conventionals after 2028. My point was not that the government is taking money from private ILG buyers. They are only a small part of the ILG market. The main effect has been to take money from peoples' pensions.

zagfles

masonic said:

It's arguable that the arithmetic mean used in RPI really was problematic and CPIH is a better measure. The change could have been made without a sustained raid if the market priced in a premium for the longer duration varieties and demanded a lower price for future auctions. But that doesn't appear to have happened. Instead, we're in a situation where inflation has to be over 1% above target just to break even. There have been long periods of time where this wouldn't be the case. For example, someone index linking for 30 years in 1992 would have had an annualised uplift of 2.8% based on RPI, which might have cost them a little vs not index linking, but if indexed on a CPIH basis would have left them around 30% worse off again. So that is the sort of thing to be factored in when considering including ILG within your bond investments as a private investor.

On the retirement income side, it makes the decision between RPI-linked and flat 3% escalation annuities more difficult than it was, since there is about a 0.4%pa cost to the former over the latter, which will mount up. Essentially, CPIH will need to be sustained at more than 3.4% (1.4% above target) for the cost to be worth it.

The 30 years from 1992 looks like a cherry picked example, most other periods RPI average has been much higher, I used 10, 20, 50, 100 years back from now in a previous post. On CPIH, ONS have modelled CPIH back to 1988 and that shows long term average CPIH from then till now was 2.9%. 

On retirement income the average inflation isn't all that matters anyway, sequence of inflation is very important. Just like with drawdown from equities it's not average returns that are important but sequence of returns. High inflation at the start of retirement will have a far greater impact than high inflation 30 years into retirement. 

In any case, for retirement income the choice been index linked and flat/fixed escalation isn't going to be based on the answer to the question "what will most likely give me the highest lifetime income". The reason people choose index linked is to have a guaranteed real income. If people want what history shows will most likely give them the highest lifetime income, they wouldn't use gilts or annuities at all, they'd use drawdown invested in equities. 

aroominyork

GeoffTF said:

aroominyork said:

You have an option whether to buy ILGs - you do not have to 'put up with it', unlike income tax which is pretty much unavoidable. 

People buy the ILGs to avoid income tax. There are no 0.125% conventionals after 2028. My point was not that the government is taking money from private ILG buyers. They are only a small part of the ILG market. The main effect has been to take money from peoples' pensions.

A benefit I also take advantage of (with conventional gilts). There may be a technical reason for it, but to me it is just a fortunate loophole.

GeoffTF said:

aroominyork said:

You have an option whether to buy ILGs - you do not have to 'put up with it', unlike income tax which is pretty much unavoidable. 

People buy the ILGs to avoid income tax. There are no 0.125% conventionals after 2028. My point was not that the government is taking money from private ILG buyers. They are only a small part of the ILG market. The main effect has been to take money from peoples' pensions.

Yes, it is at a cost to private DC pensions. While the triple lock stays in place, that represents a minor step in reducing the overall net cost of pensions to the govt while also playing a small role in reducing wealth inequalities. I say that as a reflection on the impact of moving to RPI indexing, not to open a political debate. 

GeoffTF

aroominyork said:

Yes, it is at a cost to private DC pensions. While the triple lock stays in place, that represents a minor step in reducing the overall net cost of pensions to the govt while also playing a small role in reducing wealth inequalities. I say that as a reflection on the impact of moving to RPI indexing, not to open a political debate. 

It is a cost to those who have DB pensions (including annuities) linked to RPI too, because RPI will become CPIH from 2030. The triple lock will have to go (or be watered down) at some stage anyway. It will become too costly at some stage, if it has not already done so. None of what I have written is a political comment.

aroominyork

I didn't realise DB pensions were inflation linked but I can imagine how they are.

MK62

The triple lock's inflation link is to CPI, so the changes to RPI methodology (ie to be the same as CPIH) aren't directly relevant there......

masonic

zagfles said:

masonic said:

It's arguable that the arithmetic mean used in RPI really was problematic and CPIH is a better measure. The change could have been made without a sustained raid if the market priced in a premium for the longer duration varieties and demanded a lower price for future auctions. But that doesn't appear to have happened. Instead, we're in a situation where inflation has to be over 1% above target just to break even. There have been long periods of time where this wouldn't be the case. For example, someone index linking for 30 years in 1992 would have had an annualised uplift of 2.8% based on RPI, which might have cost them a little vs not index linking, but if indexed on a CPIH basis would have left them around 30% worse off again. So that is the sort of thing to be factored in when considering including ILG within your bond investments as a private investor.

On the retirement income side, it makes the decision between RPI-linked and flat 3% escalation annuities more difficult than it was, since there is about a 0.4%pa cost to the former over the latter, which will mount up. Essentially, CPIH will need to be sustained at more than 3.4% (1.4% above target) for the cost to be worth it.

The 30 years from 1992 looks like a cherry picked example, most other periods RPI average has been much higher, I used 10, 20, 50, 100 years back from now in a previous post. On CPIH, ONS have modelled CPIH back to 1988 and that shows long term average CPIH from then till now was 2.9%. 

On retirement income the average inflation isn't all that matters anyway, sequence of inflation is very important. Just like with drawdown from equities it's not average returns that are important but sequence of returns. High inflation at the start of retirement will have a far greater impact than high inflation 30 years into retirement. 

In any case, for retirement income the choice been index linked and flat/fixed escalation isn't going to be based on the answer to the question "what will most likely give me the highest lifetime income". The reason people choose index linked is to have a guaranteed real income. If people want what history shows will most likely give them the highest lifetime income, they wouldn't use gilts or annuities at all, they'd use drawdown invested in equities. 

Yes, it was a cherry picked example to highlight even in this period, RPI linking came good, making it a no-brainer. The outcome with CPIH would have been much worse. Working backwards over shorter periods from a date just after an extreme spike in inflation is also cherry picking, even if that date happens to be the present. There will be a wide range of inflation rates over different 10 or 20 year periods in the past.

I don't disagree that inflation linking gives valuable insurance against periods of high inflation, and that it's absolutely required if you don't have the margin to absorb a higher cost of living in the short term. But it will soon come at a higher cost, so those who don't need certainty might be tempted to gamble on flat gilts or 3% escalation instead.

In many cases it won't be either annuity or drawdown, but a mixture of both, so it's worth weighing the potential cost of inflation linking if you have other options that could see you through and leave you better off in the long run, or with more income when you are younger and likely spending more.

aroominyork

For a discussion on the pros and cons of ILGs, here is a thread started last year by SnowMan https://forums.moneysavingexpert.com/discussion/6566309/index-linked-gilts-and-index-linked-annuities-are-you-moving-money-into-them-yea-or-nay/p1

zagfles

masonic said:

zagfles said:

masonic said:

It's arguable that the arithmetic mean used in RPI really was problematic and CPIH is a better measure. The change could have been made without a sustained raid if the market priced in a premium for the longer duration varieties and demanded a lower price for future auctions. But that doesn't appear to have happened. Instead, we're in a situation where inflation has to be over 1% above target just to break even. There have been long periods of time where this wouldn't be the case. For example, someone index linking for 30 years in 1992 would have had an annualised uplift of 2.8% based on RPI, which might have cost them a little vs not index linking, but if indexed on a CPIH basis would have left them around 30% worse off again. So that is the sort of thing to be factored in when considering including ILG within your bond investments as a private investor.

On the retirement income side, it makes the decision between RPI-linked and flat 3% escalation annuities more difficult than it was, since there is about a 0.4%pa cost to the former over the latter, which will mount up. Essentially, CPIH will need to be sustained at more than 3.4% (1.4% above target) for the cost to be worth it.

The 30 years from 1992 looks like a cherry picked example, most other periods RPI average has been much higher, I used 10, 20, 50, 100 years back from now in a previous post. On CPIH, ONS have modelled CPIH back to 1988 and that shows long term average CPIH from then till now was 2.9%. 

On retirement income the average inflation isn't all that matters anyway, sequence of inflation is very important. Just like with drawdown from equities it's not average returns that are important but sequence of returns. High inflation at the start of retirement will have a far greater impact than high inflation 30 years into retirement. 

In any case, for retirement income the choice been index linked and flat/fixed escalation isn't going to be based on the answer to the question "what will most likely give me the highest lifetime income". The reason people choose index linked is to have a guaranteed real income. If people want what history shows will most likely give them the highest lifetime income, they wouldn't use gilts or annuities at all, they'd use drawdown invested in equities. 

Yes, it was a cherry picked example to highlight even in this period, RPI linking came good, making it a no-brainer. The outcome with CPIH would have been much worse. Working backwards over shorter periods from a date just after an extreme spike in inflation is also cherry picking, even if that date happens to be the present. There will be a wide range of inflation rates over different 10 or 20 year periods in the past.

I don't disagree that inflation linking gives valuable insurance against periods of high inflation, and that it's absolutely required if you don't have the margin to absorb a higher cost of living in the short term. But it will soon come at a higher cost, so those who don't need certainty might be tempted to gamble on flat gilts or 3% escalation instead.

In many cases it won't be either annuity or drawdown, but a mixture of both, so it's worth weighing the potential cost of inflation linking if you have other options that could see you through and leave you better off in the long run, or with more income when you are younger and likely spending more.

Right - which is why I also used very long term (50 & 100 years, 5% and 4.5%) to get a good overall average accounting for periods of both high and low inflation. Also the recent spike really makes a mockery of relying on the BoE inflation target being met, there have been and will be circumstances where inflation will exceed, perhaps massively exceed, the target. As we've seen. 

Overall long term index linked gilts look good value IMO, despite the switchover to CPIH. I also think in the context of the massive budget deficit it must be tempting for the govt to encourage inflation, either explicitly (eg changing the BoE target) or through other actions. Inflation will definitely help solve the deficit problem - stealth taxes (freezing allowances etc) become more effective, non-indexed govt debt reduces in real terms (IIRC non-indexed is about 75%) and tax revenue will likely increase with inflation (VAT, income tax etc). 

So personally I won't be touching non indexed govt debt or flat annuities with a bargepole, I will use index linked gilts/annuities for core income and equities for the cherry on top.