The retail prices index (RPI) is expected to fall into negative territory for the first time in almost 50 years next week. This measure of inflation is used to calculate pensions, pay rises, student loans and some savings rates, leaving many people worried about the impact on their finances.

Here we explain what a negative RPI will mean for your income and borrowing.

Pensions and benefits

The state pension increases every April in line with the previous September's RPI figure, so it rose by 5 per cent this month, from £90.70 a week to £95.25. The good news for pensioners is that it will never increase by less than 2.5 per cent, regardless of how far the RPI falls.

However, those who have bought an annuity with a money-purchase pension may be facing a drop in their income. Level annuities, where a fixed amount is paid every year, are not affected by RPI fluctuations. However, with index-linked annuities, income increases every year in line with inflation. But if the RPI falls below zero, income could actually decrease.

So far, Norwich Union, Legal & General and AXA have said that they will not reduce income payments, but those who bought annuities with Prudential and Standard Life could suffer a fall in their income.

Payouts on index-linked annuities are normally set annually, three months before the anniversary of when the policy was bought. So if you bought in July, your income will be set for the next 12 months in line with the April RPI.

Laith Khalaf, of Hargreaves Lansdown, the independent financial adviser, says: “Pension investors who bought index-linked annuities may suffer in the short term. But inflation will undoubtedly return and provide a significant problem for pensioners in the years to come. Therefore, it is still a smarter move in the long term to buy index-linked annuities.”

Other government benefits, such as the carer's allowance, disability living allowance and injury benefits are also linked to September's RPI. Like the state pension, these benefits increased by 5 per cent last month. If the RPI is at 0 per cent or lower this September, the Government says that benefit levels will not be reduced.

Savings

Only returns on National Savings & Investments index-linked saving certificates fall in line with the RPI. The certificates, which are held for three or five years, pay a fixed rate - currently 1 per cent - plus RPI, which is added on each anniversary of the certificate. If RPI is 0 per cent or lower, no index-linking is added.

However, falling inflation is generally good news for the real value of savings returns. With the Bank of England base rate now at 0.5 per cent, savings rates have plummeted in recent months and more than half of all accounts now pay less than 0.5 per cent.

Michelle Slade, of Moneyfacts.co.uk, the financial website, says: “In spite of falling interest rates, things are not quite as bad as they seem for savers. With the RPI falling to 0 per cent, the real returns that savers are getting on their money have improved. Falling prices in the shops mean that savers can buy more with the same amount of money.”

Student loans

About two million graduates are repaying student loans that are subsidised by the Government to provide a low rate of interest linked to the RPI.

Loans taken out before September 1998 have interest set every September in line with the RPI from the previous March. The RPI for March this year will be released on Tuesday. The rate on these loans is currently 3.8 per cent, but if the RPI is still at 0 per cent on Tuesday, borrowers are likely to pay 0 per cent for 12 months from September.

It is still unclear what will happen to student loans if the RPI falls below zero, with the Government only saying that it will make a decision “at the appropriate time”.

Pay settlements

While there is not usually an automatic link between the RPI and wage increases, the index is often used as the benchmark for inflation when negotiating pay deals. Unions fear that many employers, already under pressure in the recession and forced to make redundancies, may seize on the prospect of a negative RPI to freeze or lower wages in the coming months.

Brendan Barber, of the Trades Union Congress, says: “While many workers have agreed to modest or even zero increases in pay to save jobs, a generalised wage freeze across the economy will make the downturn worse, not better.”

Why the RPI and CPI differ

While the retail prices index fell to 0 per cent in February, the consumer prices index (CPI) - the Government's preferred measure of inflation - jumped unexpectedly to 3.2 per cent.

The rise in the CPI was largely a result of the increasing cost of vegetables, bread and meat. The average price of petrol climbed by 3.2p a litre between January and February, and the cost of furniture and household appliances also rose.

RPI was lower because it takes into account housing costs. Homeowners on tracker and some variable-rate mortgages have enjoyed lower monthly repayments thanks to cuts in the base rate.

Jonathan Loynes, of Capital Economics, the research consultancy, says: “CPI may be above the Government's 2 per cent target now, but it will fall over the coming months, with the cost of gas, electricity and food exerting downward pressure. We expect CPI to hit 0 per cent by September and could even go negative, like the RPI. Deflation will soon be a reality.”

Case study - Lower-cost student loan

Kerry Muggeridge, 21, is a final-year student at the London School of Economics. She graduates this summer with a £13,500 student loan, which will be repaid from April next year once she is earning more than £15,000.

Ms Muggeridge hopes that by the time she starts repaying her loan the interest rate will have been set the previous September at 0 per cent.

“It is difficult starting work saddled with such large debts, so it would be good if my repayments are kept as low as possible,” she says. “I know that interest payments will increase as inflation rises again. But in the meantime it is good news for people graduating this year.”

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