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[uk_rpi] [tentative_conclusions]

Current gilts-based inflationary expectations just haven't been working well. They have mostly tended to be biased too high, with the converse in recent years. The standard approach is mandatory for PPF calculations (which are meant to be “prudent”) and merely recommended for FRS17 (or IAS19) calculations (which are intended to be “realistic”). One point which needs to be taken into account is that prudence can only be assessed against a best estimate. If the current general approach is hardly “best estimate”, it is hard to see how it can possibly be taken as prudent. We suspect it is actually “super-prudent”, directly leading to huge capital and social losses, in the form of wildly inflated deficit payments inflicted upon business stakeholders and losses of valuable pension rights by a huge number of employees.

This has led to continuing significant corporate accounting distortions and we think this matters. Broadly, liabilities are being overstated by at least 25% and possibly substantially more than that.

Over periods of 15 years until the end of 2019, all 3 approaches converged to just under zero, which looks good. However, the volatility has been huge. Over all periods of 15 years, all three approaches overstated the position, the averages being worst for gilts (1.36%), not quite so extreme for spot (0.99%) and best for forward (0.26%). The worst overestimate was 3.98% (gilts) and the worst underestimate was 1.63% for forward. These figures do not suggest that we can rely upon them.

All in all, we can't assume that the results until 2019 (or any other year) are truly indicative. While not perfect, “forward” is the measure with “best pedigree” so far encountered. An even higher deduction might be justified, but we favour using “BoE forward 15 minus 1% pa”. Were we to stick with the gilts approach, then we would suggest deducting at least 1% pa and possibly as much as 2% pa. If RPI is replaced by CPIH for ILG payments, that will make the common approach even less justifiable.

Looking back at recent volatility, we wondered how the FRS17 discount rate would have varied, both gross and net. A chart shows “assumed inflation” (based upon the gilts approach), the AA corporate bond yield and the net rate (simple). It is hard to see how this can be described as a best estimate.