The wedge and the hedge

There are admittedly other topics in the news more likely to set the heart aflutter than the continuing implications of the government’s decision to use the consumer price index (CPI) rather than the retail price index (RPI) as its measure of inflation for pension increases.

But, away from the Brexit brouhaha and the Trump administration’s troubles, this area has received increased attention of late, after a House of Lords inquiry criticised the UK Statistics Authority’s stance with respect to RPI as “untenable” due to flaws in the index’s design.

The inquiry also recommended that the government should begin to issue CPI-linked gilts and stop issuing RPI-linked sovereign debt. This could have significant knock-on effects for investors – not least defined benefit (DB) pension schemes, which used index-linked paper to hedge their liabilities against inflation.

DB schemes have substantial CPI exposure in their liabilities, as the government has used the index to determine increases in both public and private sector occupational pension schemes since 2011. Yet they also hold substantial assets linked to the older measure of inflation – a mismatch that creates risk.

Indeed in isolation, we estimate that an RPI-linked asset used to hedge a CPI-linked liability ‘only’ reduces volatility in a scheme’s funding level from 10% per annum to 6% per annum, if 100% of the scheme’s liabilities are linked to CPI.

Put another way, this residual risk is comparable to that of a 40% allocation to developed market equities. Which is not insignificant, to say the least!

At the same time, the market also has to contend with a series of unknowns regarding the future of RPI, such as whether the government will take action that adversely affects schemes’ assets linked to the measure relative to their CPI-linked liabilities.

The growing attraction of CPI-linked assets

There are also opportunities among these challenges, however. Current market pricing indicates that this risk can be mitigated at relatively favourable rates compared to those previously available, due to the increased supply of CPI-linked instruments to the market.

Indeed, the difference in pricing for CPI and RPI interest-rate swaps at 10 to 15-year maturities has been trending towards what many market participants view as fair value.

The risk-return impact for any particular scheme in replacing RPI-linked assets with securities linked to CPI will, of course, be unique. But by way of example, we looked at whether it might be worthwhile for a scheme with all of its liabilities linked to CPI. Given other sources of risk in the scheme of 5% pa, and a liability hedge ratio up to the value of its assets, we found that there is a case to hedge more than 80% of the CPI-linked liabilities with CPI-linked assets – even if this is perceived (relative to 'fair value') as sacrificing 40 basis points per annum of investment returns on those assets switched to CPI.

As the discussions over the future of RPI continue, we believe that clients who are well hedged, exposed to a material amount of CPI risk and enjoy a reasonable governance budget, may be best placed to explore CPI assets in greater detail.

Please click here for our deep dive on the subject, which includes an outline of the research and modelling on which these conclusions are based.