How to prepare for a switch in inflation hedging

RPI is typically higher than CPI and as a result, using CPI will likely decrease future pension liabilities. What, if anything, should pension funds be doing now?

Funds should continue to use RPI-linked assets in the near term as their default inflation-hedging assets, adopt a ‘dynamic’ approach to hedging inflation-linked liabilities and consider the inclusion of alternative asset classes that can provide CPI-linkage.

In the near term, RPI-linked assets should continue to be the default inflation hedging asset.

Challenges with CPI

There is limited availability of CPI-linked assets. The RPI-linked asset universe consists of index-linked gilts, RPI-swaps, a limited universe of non-government index-linked bonds along with alternative asset types that provide a degree of inflation protection.

CPI assets purchased now may not provide a direct hedge to pension liabilities

In contrast, conventional CPI matching assets are hard to find. The government recently considered issuing CPI-linked ILGs, but concluded that there wasn’t a sufficiently strong case to do so. Furthermore, there is not yet a functioning market in CPI-linked swaps.

The 30-year-plus maturity ILG breakeven RPI levels are at multi-year lows of 3 per cent or lower.

Assuming the broadly held expectation that year-on-year changes in RPI will, on average, be about 1 per cent higher than CPI annually over the long term, this implies investors would pay a negligible inflation risk premium if the Bank of England were to achieve its 2 per cent CPI target in the long run.

There is considerable uncertainty around which CPI measure may be the default in the future, meaning even CPI assets purchased now may not provide a direct hedge to pension liabilities.

In 2013, the Office for National Statistics launched the consumer price inflation including owner occupiers’ housing costs index.

While the index does not currently have National Statistics status, the ONS has made improvements with the objective of achieving this. It is possible that ultimately CPIH will become the primary inflation measure in the UK.

If investors were to use RPI as a proxy for CPI, they would be exposed to the differences between the two inflation measures, resulting in imprecise hedging.

This can be mitigated by using a dynamic approach to hedging inflation, where inflation exposures within the asset portfolio are reviewed, and adjusted if required, as market levels change.

This is an approach sophisticated schemes already use in managing limited price indexation liabilities, which are annual pension increases indexed with a cap and floor applied, typically resulting in a portfolio that blends nominal and inflation-linked asset exposures.

CPI exposure

While conventional CPI-linked assets are scarce, certain alternative assets do offer CPI-linked inflation exposure.

Renewable income assets related to UK wind and solar projects can enable access to CPI-linked cash flows at attractive pricing levels.

Lifetime mortgages, which are loans secured against a property, increase at a specified rate, typically fixed or at a spread to CPI, allowing institutional investors the ability to gain exposure to assets providing long-dated CPI-linked cash flows.

Ofwat, the water regulator, recently proposed changing the measure of inflation it uses to set bills and financial returns to CPI from RPI. This would not come into effect until 2020 – but could result in an additional source of CPI-linked assets over the longer term.

Doug Graham is managing director, client solutions at BlackRock