The consumer price index spiked by almost half a per cent in the year to December 2016, narrowing the ‘rules lottery’ gap between the official inflation measure and the retail price index.
Publishing the results on Tuesday, the Office for National Statistics also said that increased producer prices, as a result of a fall in sterling, have started to feed into consumer prices, with the implication that inflation could rise further in 2017.
While economists are broadly upbeat about the prospect of a reflationary economy, the picture for pension schemes is less clear, as a rise in prices could impact schemes’ inflation-linked liabilities.
Long-term interest rates and long-term inflation are close to what we would see as fair value
Tony Baily, Cardano
CPI finished 2016 with a 12-month rate of 1.6 per cent, up from 1.2 per cent in the year to November. Meanwhile RPI’s yearly rise increased to 2.5 per cent, from 2.2 per cent in November.
Rules wording is everything
The narrowing of the gap between the two measures means in theory that schemes with RPI hardwired into their rules, via what is often termed the ‘rules lottery’, should not see their financial outlook vary as significantly from the norm as it has previously.
But according to Matthew Giles, partner at law firm Squire Patton Boggs, the overall trend of increased inflation could add a further layer of complexity to that lottery as RPI moves above the 2.5 per cent increase cap used by many schemes.
The cap on benefit increases was first introduced at 5 per cent, followed by a reduction in the statutory cap to 2.5 per cent in 2009.
“When the cap went down to 2.5 per cent in statute [...] some schemes followed suit and some schemes didn’t,” said Giles. “It’s like a double whammy of the rules lottery.”
Should hedge strategy change?
For Tony Baily, client director at Cardano, higher consumer prices in some areas imply that further short-term inflation will ensue, but that the same rise cannot be expected for the next 20 to 30 years, which is of greater concern to schemes.
How to prepare for a switch in inflation hedging
The move to link liabilities of pension schemes to the consumer price index, rather than the retail price index, has recently become a topic for debate.
“Long-term interest rates and long-term inflation are close to what we would see as fair value,” he said, but added that fully hedged schemes might tolerate a slight tweaking of their LDI programme away from expensive inflation protection.
Vivek Paul, director in BlackRock’s client solutions team, said the current figures did not signal a need to hedge inflation more than interest rates, especially when compared with the case for doing so after the June referendum.
However, he added that for the majority of schemes, increasing their overall hedge ratio would remain a priority.
If nominal interest rates were to rise further, he said, “perhaps that’s when they might want to take a bit more risk off the table”.
