Daily Mail grabs alternative inflation linkage in place of pricey gilts

The National Association of Pension Funds this week released a report outlining the potential challenges faced by defined benefit schemes as overall funding levels increase and those wishing to derisk switch investments from equities towards liability-matching assets.

Speaking at an NAPF derisking seminar yesterday, Mike Weston, chief investment officer of the fund, said the price of index-linked gilts caused the scheme to look elsewhere when matching liabilities.

“Index-linked gilts are the ideal liability match and if they were cheaper we would have bought that and not bothered with more complex stuff,” he said. “We just didn’t feel that they gave good value to our pensioners.

Picking assets

The scheme looked into a range of alternatives to traditional index-linked bonds. These included infrastructure, commercial real estate and alternative credit such as bank capital replacement trades.

The scheme invested in infrastructure through 20-year and 25-year core infrastructure public private partnerships and private finance initiatives, but Weston said that as the scheme matured it would likely move towards more liquid assets.

“It’s inevitable that as the [funding] ratio goes up then the attitude will become more positive and the asset allocation will change,” he said. “As we get closer to peak cash outflow, the length of time we can hold illiquid assets in the portfolio will go down as we need to be able to realise them to pay the pension.”

The DMGT scheme has around £2bn in assets, with approximately £2.2bn in liabilities, delegates heard. It closed to new members in 2011, the same time that it began calculating future accrual on a career average basis.

Weston said that the declining active membership (see box) was an important factor when creating a strategy for  matching liabilities.

“We have a peak cash outflow between 2030 and 2035, and after that the cash outflows to pay pensions declines quite rapidly,” he said.

“So effectively when we’re thinking about investment strategy and liability management strategy we’re thinking most closely about the period running up to that peak, and how do we make sure we can get to that peak with enough assets to pay pensions as they fall due.”

Associated risks

In its report, entitled DB Run Off: The Demand for Inflation-linked Assets, the NAPF highlighted the risks inherent in the increasing demand for alternative inflation-linked assets.

“In the absence of sufficient index-linked gilt issuance, the availability of alternative investments becomes even more important,” the report states. But it adds: “Investment is likely to remain accessible only to a small number of the very largest schemes.”

Ruth Meade, senior researcher at the NAPF, said the increasing demand may require a combination of measures. “Schemes need increased issuance of index-linked gilts, better availability of alternative inflation-matching assets and the development of a framework that allows for a more flexible model of DB pension provision,” she said. 

Despite this, Weston said that financial markets would likely find a way to meet demand.

“Where there is demand from pension schemes the financial markets are pretty good at anticipating and providing supply,” he said.

“We won’t always like the forms that these opportunities arise in or we might not always like the price, but the industry is pretty good at coming up with opportunities.”