UK's £80 Billion Pension Blunder?

A staggering £80billion has been wiped off the value of pensions because the rate of inflation has been underestimated for 12 years, it emerged last night.

Millions of pensioners relying on occupational schemes have been left hundreds of pounds short each year because their retirement benefits have not been increased to reflect the full rise in inflation.

A 0.3 per cent a year underestimate of the effects of inflation over 12 years comes to 4 per cent.

John Ralfe, one of the UK's leading independent pensions consultants, said: ‘In simple terms, for every £100 of pension you are receiving, you should be getting £104.'

Details of the blunder come just days after the Bank of England admitted that inflation this year is likely to rise from 4 to 5 per cent.

High inflation can be devastating to pensioners because their incomes fail to keep pace with rising costs and the real value of their savings dwindles.

The Bank admitted to the miscalculation in its quarterly Inflation Report, saying the Consumer Price Inflation should have been 0.3 per cent a year higher between 1997 and 2009.

The figure was lower because the Office for National Statistics failed to take into account changes in the prices of clothing and shoes which were affected by hefty discounting in the sales.

The ONS changed the way it records the prices of clothes and shoes in January last year.

The impact on Retail Price Inflation would have been even greater but the Bank did not disclose how much. Most pensions are linked to the RPI and rise in line with that figure.

The Bank said the miscalculation was the responsibility of the ONS. It means that for 12 years, the increases to pensions for inflation have not reflected the true rise in the cost of living.

More than 17million people were either pensioners or deferred pensioners in final salary schemes in 2009 and could be affected.

John Broome Saunders, actuarial director at BDO Investment Management, said: ‘If you went to every final salary pension scheme in the UK and recalculated the benefits using the right inflation figure, you would increase the total value of pensions by around £80billion.

‘This is pretty shocking stuff at a time when people are worried about their pensions. It is certainly very worrying that the government statisticians didn't get this right.

‘It is yet another thing reducing people's confidence in the Government's management of pensions.'

Mr Saunders said the value of entitlements to final salary pensions from employers, the public sector and local government was around £2trillion. The 0.3 per cent underestimate over 12 years comes to 4 per cent, or £80billon.

The true impact on pensions may be even greater because most are increased either in line with RPI or earnings, both of which are normally higher than the CPI figure.

John Prior, a pension consultant with Punter Southall, said: ‘This will affect anyone who has been in a final salary scheme over that period.

‘It includes people who are already retired and deferred members, or people who have left a company but not yet drawn their pension.

‘It would indirectly affect current employees because their pay rises and pensions may have been less.'

The ONS said: ‘This is not a blunder. Our figures aren't wrong – we have simply improved the way we calculate inflation.'

But Laith Khalaf, from financial advisers Hargreaves Lansdown, said: ‘Pensioners have a tough time battling inflation as it is. They will be up in arms that their income has been held back in this way.'

Pensioners were cheated out of £80billion during 12 years of Labour rule, it was revealed yesterday.

In a bitter blow to millions, the Bank of England's February inflation report showed the Consumer Prices Index between 1997 and 2009 was 0.3 per cent a year higher than official figures had previously stated.

Experts say this miscalculation by the Office for National Statistics cost the average final salary pension holder hundreds of pounds a year.

Outraged pension groups said there was currently no way for any of the eight million people affected to claim compensation.

Dr Ros Altmann, director general of the over-50s group Saga, complained: “How much pain do pensioners have to endure?”

John Broome Saunders, actuarial director at BDO Investment Management, said: “Had the inflation calculation been done correctly, many final salary scheme members would now find themselves entitled to a pension around four per cent higher.

“This doesn't just affect pensioners – deferred scheme members have also been denied a similar level of increase.”

Many pension schemes link payouts to the Retail Price Index, which is directly affected by the level of CPI.

Richard McIndoe, head of pensions at Strathclyde Pension Fund, said: “Pensioners will feel aggrieved when they see this, and they think they should have received four per cent more.

“In reality, however, there is not much to be done about it. The official inflation figure is still the official inflation figure.” Joanne Segars, chief executive of the National Association of Pension Funds, said: “It's true that state and occupational pensions would have been higher if this new measure had been applied. But all that pension schemes can do is work with the figures they have been given.”

The CPI error stemmed from the misreporting of clothing prices. The inflation report said: “Previous collection methods may have biased down estimates of CPI clothing prices.”

Last night a spokesman for the Office for National Statistics said: “ONS has improved its methods for collecting clothing prices as part of its development programme but this does not mean that there were measurement errors or misreporting in the past. The Bank of England agrees with ONS that the improved collection practices for clothing better reflect current consumer behaviour.”

But Saga's Dr Altmann said much now needed to be done to protect pensioners.

She said: “The Bank of England needs to get a grip and show its determination to combat the ravages of inflation on savers and signal its intent to start raising interest rates.

“At the moment savers and pensioners are being hit by low interest rates and high inflation, and Saga is deeply concerned.

“We believe that a small rise in interest rates would send a positive signal to increasingly desperate savers, without having an adverse effect on the economy.

“The sooner the Bank acts, the better.

“Pensioners have already been hit hard by the economic crisis. They are suffering from extremely low interest rates and very high inflation, which means that the value of their savings is being eroded.”

Falls in stock markets and rising inflation have led to a typical 65-year-old now entering retirement with a private pension of just £7,666 a year.

This is almost half the officially recognised income needed to maintain an adequate standard of living.

The National Association of Pension Funds pointed out that pension increases are dependent on published inflation rates, which remain as they were.

"It's a theoretical argument," explained Ros Altmann, Saga Group director general.

"You would have to prove that this is the only element of inflation that needed to be changed," she said.

The policy of the Department for Work and Pensions is that it will only change benefit rates if the official inflation figure is recalculated and republished.

A DWP spokesperson said: "Inflation figures are determined by the ONS who regularly do work to improve their methods of calculation.

"Any changes in methodology do not mean that previous inflation rates were incorrect."

But changes in methodology which are in line with what the public has known for years, namely, that inflation is grossly underestimated, only proves that pensioners and workers are getting squeezed on all fronts. After all, wages and pensions are linked to CPI. Welcome to the new normal, which is pretty much the same as the old normal except dressed in different clothing.

***Update***

Bernard Dussault, former Chief Actuary of Canada, sent me these comments:

This UK CPI error is much larger than the one (0.1%) made by Statistic Canada each month over 5 years from March 2001 to March 2006.

STATCAN's error represents an average lump sum of about $30 for each CPP recipient, $30 for each OAS recipient and $125 for each federal pensioner (i.e. public sector retirees). This assumes average pensions of $6.000, $6,000 and $25,000, respectively (e.g. 0.5% times $25,000 equals $125). Total additional pension tab would have been about $150 m for each of CPP and OAS and $25m for public sector superannuation plans.

Government decided to adjust the CPI prospectively, but not retroactively because it would have given rise to the re-opening of too many important salary negotiations in Canada.

And here is a copy of the Globe and Mail article published August 16, 2006 soon after the error was disclosed by STATCAN:

Statscan admits five-year inflation mistake
TAVIA GRANT
Wednesday, August 16, 2006

Canada's federal statistics-gathering agency admitted yesterday it mistakenly understated the country's inflation rate over the past five years.

Statistics Canada said the overall consumer price index was miscalculated, on average, by a tenth of a percentage point between early 2001 and March of this year.

A glitch in a computer formula meant the agency was wrong about the price of hotel and motel rooms during the period: Statscan had reported that room rates fell 16 per cent when they really rose 32 per cent. The error in that CPI component threw off the whole index.

Statscan said it didn't catch the mistake earlier because anecdotal evidence suggested Canada's tourism industry was facing tough times, hence the price pressure.

It's an embarrassing blunder for an agency that's been lauded by the likes of The Economist magazine and the International Monetary Fund as being the best of the best.

The consumer price index is one of the most closely watched monthly economic indicators because the Bank of Canada uses it to help set interest rates.

The index, which includes data on what shoppers pay in stores and hair salons and at the pumps, also influences old-age pensions, rental agreements, child-support payments and wages.

The error isn't enough to have swayed the Bank of Canada on any past interest-rate decisions. It does, however, erode confidence in an agency that, just in April, acknowledged Canadian productivity last year was twice the level that was previously announced.

"I think it will raise more questions," said Doug Porter, senior economist at BMO Nesbitt Burns Inc., who noticed in March that the hotel inflation rate looked odd. "It's one of the more common issues that we deal with, whether CPI is accurately capturing the real inflation that people face. Unfortunately, this episode just further heightens that issue."

The CPI is never revised and won't be this time. Statscan and other agencies around the world have agreed not to revise inflation numbers because that could wreak havoc on all the contracts, such as wage settlements, that rely on the inflation data.

Mr. Porter continues to believe the CPI is accurate and that Statscan does a good job of tracking it. "I still think it's the best measure of inflation we have."

Other economists were taken aback by the glitch, reported by Bloomberg News yesterday and which first surfaced as a footnote in Statscan's June price inflation, released July 21.

"It's a surprise and [so is] the fact that it was going on for a long period of time and they hadn't caught the miscalculation up until this point," said Mark Chandler, senior financial economist at Scotia Capital in Toronto. "It opens questions on how many other components are suffering from something like that. It does hurt their credibility a little bit."

The Bank of Canada said the error hasn't caused it to rethink its past interpretation of the economy, nor is the central bank reassessing its economic outlook.

"The bank has great confidence in the overall reliability of the CPI as a measure of inflation," spokesman Jeremy Harrison said.

The bank, along with most economists, is aware that there's a margin of error. A study last year by the central bank found that Canadian CPI overstates inflation by about 0.6 percentage points a year.

Canada's monthly consumer price index tracks the prices of more than 600 separate goods and services in 169 classes. The CPI division employs about 150 people across the country who work on collection, computation, analysis and research, according to Tarek Harchaoui, assistant director of the division. Statscan employees spend hundreds of hours every month checking numbers and doing quality control, he added.

On the world stage, Statscan is highly regarded. In two surveys conducted by The Economist in the 1990s on world statistical agencies, Statistics Canada ranked No. 1 both times. More recently, the International Monetary Fund reviewed Canada's CPI in 2003 for adherence to international standards and found it complied with 15 out of 15 measures of quality.

That's not to say the agency is immune from criticism. Some have questioned how it measures car insurance and house prices. The price of clothes, which has dived in recent years, may also become a subject of debate, one economist said.

For many Canadians, this will simply confirm suspicions that inflation is rising at a faster pace than what the government says. But, as economists have noted, consumers tend to notice when prices go up and not realize that costs for, say, a new computer or a coffee maker, have actually fallen over the years.