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Index Linking Periodical Payments

Andrew Campbell, barrister, Queen Elizabeth Building, analyses the impact of indexation on periodical payment awards with illuminating practical examples showing why this aspect of the award can make a material difference to the payer and the payee.















Andrew Campbell, barrister, QEB 

Index-linking: of inflated importance?
Index-linking is the mechanism by which periodical payments increase in line with inflation. It is often an afterthought and frequently conceded, whether by the payer or payee, but sometimes fought tooth-and-nail. But how much is index linking actually worth? What is the practical difference between an index-linked and non-index-linked order?

It is often said by economists that inflation helps to "grease the wheels" of the economy. The rationale is that workers like to see their incomes rise, and pay rises in line with inflation give the illusion of advancement despite no change to income in real terms.

However, for those who are recipients of periodical payments awards, a flat rate of payment with no index-linking means that the real value of the sums received gradually decreases over time. As is set out in greater detail below, because of the 'compound' nature of inflation the effect becomes more pronounced over terms of significant length.

Inflation is now at a five-year high of 3% per year. Of course, the greater the level of inflation the more that the real value of a fixed sum diminishes over time, and the bigger the relative benefit of an index-linked award.

However, index-linking makes an order more complicated to understand for lay clients. It is not uncommon for practitioners to see situations where some years after the order neither of the parties have ever made any adjustments for index-linking, or it has been done sporadically. Not every client is an economist or lawyer. It is hard to imagine many lay clients taking the usual drafting of index linking clauses in their stride, particularly once they no longer have lawyers helping them to interpret the terms of the order.
Of course, no practitioners want to create a situation where their client is in breach of an order because the ramifications of an index-linking clause were not fully explained to them at the time of the order. This is particularly problematic where such clauses are introduced last-minute at an FDR and there is not the luxury of time to run through the minutiae of any provision in exhaustive detail.

Provided those problems are overcome, the effect of index-linking can be surprisingly large.

Illustration
The table below provides an illustration of the relative benefit of index-linking as compared to a flat rate. Assume the paying party is ordered to pay £1,000 per month (£12,000 per year) for 10 years, and that the rate of inflation is a constant 3% (which of course is the assumption under a Duxbury calculation). The table shows the increase year-on-year over that 10 year term:

Table 1

 

Year

No index-link

Index link: 3%

1

£12,000

£12,000

2

£12,000

£12,360

3

£12,000

£12,731

4

£12,000

£13,113

5

£12,000

£13,506

6

£12,000

£13,911

7

£12,000

£14,329

8

£12,000

£14,758

9

£12,000

£15,201

10

£12,000

£15,657

Total

£120,000

£137,567





Total difference

£17,567



Although the difference starts off small, by year 10 the payments are around £15,650 per year and around 30% higher than the corresponding non-index-linked payment of £12,000. Over the ten year term the total payments are around £17,500 higher, which is equivalent to more than a whole year of payments.

Because of the nature of inflation, increases are compound and so the longer the term the more valuable index-linking can be. The compound percentage change can lead to stealthy increases over time that lead to striking results.

Using the same assumptions as above, over a 15 year term in a non-index-linked order will remain at £12,000 per year (£1,000 per month), but index-linking will lead to around £18,000 in year 15; a 50% increase. The total payments over those fifteen years will be £180,000 in a non-index-linked order but around £223,000 in an index-linked order. The difference of around £43,000 is equivalent to just over three and a half years of extra payments.

Of course, all of this assumes that the term and quantum of payments play out in full per the terms of the order and there has been no variation of the order or missed payments. Furthermore, as more time passes the more likely it is that circumstances change and grounds for variation of the order can arise.

But if those assumptions hold good then over a long-term periodical payments order index-linking can lead to significant increases in the amounts paid, particularly in the final years of the term. By contrast, if it were only a five year term the total increase in payments would only add around an extra £3,000, i.e. 3 months of payments.

Method of index-linking
Another question is whether to rely on the retail price index (RPI) or the consumer price index (CPI), Again, is this an academic debate or does it lead to practical differences on the ground of how much money is paid?

The RPI and CPI measures are two of a number of different ways of tracking inflation, but are by far the most common if not the only alternatives used by family lawyers. Without boring the reader, the way they work is aggregating a hypothetical 'shopping basket' of goods and services containing all the things that a consumer would expect to spend money on, and then tracking the overall cost of this conceptualised shopping basket over time.

Clearly, the question of what goes into the basket can alter, not only over time but between indices. One difference between the measures is that RPI includes the costs of private rentals, mortgage interest costs and council tax, whereas CPI does not. A common argument among family lawyers is therefore that where the receiving party has enough of a capital sum to purchase a property mortgage-free then there are no mortgage repayments or rental costs and so CPI is more appropriate.

As a passing note the Office for National Statistics now use the altered CPIH as their 'headline' measure of inflation which does include the cost of housing.

The RPI also excludes the goods and services purchased by pensioners, tourists, and the top 4% of earners. The CPI includes all expenditure by persons in all of those categories.

There are more fundamental mathematical differences. The RPI measure is an arithmetic mean, which is a simple calculation involving adding everything up and dividing by the number of items. The CPI is a geometric mean which means multiplying all of the items together and finding the root of the items. This is difficult to conceptualise, but the general view among professional statisticians is that the CPI measure is much more methodologically acceptable, partly because the CPI model factors in changes in consumer spending as prices change. Since 2003 the CPI is the measure used by the Bank of England and is also the internationally-recognised measure of inflation.

The UK is the only one of the 27 EU countries that persists with using the RPI measure in some form. Even now its popularity is waning and the poor RPI has been ostracised and it now no longer receives the official designation as a 'National Statistic', although the Office for National Statistics still produces it, mainly for historical reference purposes.

Because of the contrast in the methodology and the nature of what is included in the measure, it is likely that the CPI will be lower than the RPI. A rough rule of thumb is that it is about 1% lower, although it does vary and sometimes the CPI on a month-to-month basis will be higher than the RPI. At the time of writing, inflation on the CPI measure is 3% and on the RPI is 4%.

If you are acting for the paying party, put forward the CPI measure, if index-linking. Be aware of the objections regarding costs of housing if the receiving party is paying rent or making mortgage repayments. If you are for the receiving party, particularly if your client is going to pay rent, mortgage interest payments or council tax, argue for the RPI measure, but bear in mind the arguments that may come regarding its somewhat obsolete nature.
The table below illustrates the practical difference (or lack thereof) between the two measures, which may be of some interest when assessing whether the argument is a meaningful one. It assumes the same figure of £1,000 per month (£12,000 per year) and that the order dates from November 2007. There have been ten years (120 months) of payments since then to October 2017. Three situations are compared: (i) no index-linking; (ii) the order index-linked to CPI; and (iii) the order index-linked to RPI, and historical index rates (obtained from the ONS website) are used for illustrative purposes.

Table 2

 

Year

No index-link

Index link: CPI

Index link: RPI

Nov 2007 - Oct 2008

£12,000

£12,000

£12,000

Nov 2008 - Oct 2009

£12,000

£12,480

£12,361

Nov 2009 - Oct 2010

£12,000

£12,727

£12,395

Nov 2010 - Oct 2011

£12,000

£13,135

£12,979

Nov 2011 - Oct 2012

£12,000

£13,760

£13,648

Nov 2012 - Oct 2013

£12,000

£14,138

£14,054

Nov 2013 - Oct 2014

£12,000

£14,429

£14,426

Nov 2014 - Oct 2015

£12,000

£14,560

£14,712

Nov 2015 - Oct 2016

£12,000

£14,589

£14,867

Nov 2016 - Oct 2017

£12,000

£14,749

£15,193

Total

£120,000

£136,567

£136,635




There is therefore no real difference between the CPI and RPI measures when looking at the historical data: although RPI index-linking leads to an extra £400 in the final year of the term the total payments are virtually identical. Do note however that the years following 2007 were somewhat anomalous given the impact of the financial crisis, and the RPI is expected to be higher.

However, both are significantly better than the non-index-linked payment: around £16,000 more over the term, equivalent to more than a year's worth of extra payments.

In summary, in situations where the term length is significant and the underlying personal circumstances are unlikely to change significantly so that a variation in the order is not anticipated then index-linking can lead to significant differences in the later years of the terms and therefore the total payments made under the order. The recent rise in the Bank of England base rate has been motivated in part by the increase in inflation and, of course, the B-word (Brexit) may further put upward pressure on prices. The higher the level of inflation, the more valuable index-linking becomes. Practitioners should be aware of the consequences and be able to advise lay clients accordingly. However, historical data shows that there have been limited practical differences between the CPI and the RPI and which index is preferable depends on whether the client is the paying or the receiving party, albeit a larger disparity is expected between the two measures in future.

November 2017