Nearly half of pension fund trustees have incorporated longevity or swap contracts to tackle inflation risk, an upcoming survey will show, having benefited from favourable pricing last year to boost protection.
Of the 250 respondents to Pension Insurance Corporation’s fourth annual survey, 45 per cent said they had “taken steps” to reduce the impact of price rises on their investments. The same proportion again said they viewed inflation as a “minor” consideration
Schemes use hedges to protect their overall investment strategy from the movement of a particular economic indicator or market risk.
Inflation hedging spiked in 2012 as the relatively low cost of around 3 per cent a year for an inflation swap meant schemes were effectively able to mitigate the risk of a rise in prices without paying a premium for the privilege.
This view has paid off for many schemes, said chair of the Society of Pension Consultants’ investment committee Tony English. “Now that breakeven inflation has increased, future hedging activity is likely to be driven by the desire of pension schemes to increase hedge ratios on an outright basis,” he said.
“While such activity will no doubt be restricted by the current prevalence of negative real yields, if the rally in risk assets continues, further hedging activity should still be expected as some pension schemes look to protect funding level improvements.”
The Co-op's hedging strategy
The Co-operative Group’s Pace pension scheme uses a range of derivatives to hedge inflation and interest rates as part of a wider liability-driven investment strategy, and it plans to further increase its level of protection, said pension finance and risk controller Mike Thorpe.
“The liability-matching portfolio is split between bonds (40 per cent) and LDI (60 per cent) that together currently hedges 58 per cent of the interest rate risk and 72 per cent of the inflation risk,” he said, “with plans to increase this to 75 per cent of both.”
Thorpe added that the scheme had increased its interest rate more than the inflation hedge over the past year “to extend that hedge when nominal gilt yields have been higher than a set of triggers based on our view of long term fair value for gilt yields”.
Compared with inflation, interest rate hedging witnessed more muted activity in 2012, with the average increase probably no more than 5 per cent of assets for larger schemes, according to Phil Page, client director at fiduciary manager Cardano.
“Interest rate swaps were offering rates of around 3 per cent or less, which is well below historical levels, so trustees were reluctant to hedge more,” he said. “In fact, interest rates have fallen further, so this was a mistake with the benefit of hindsight.”
Trustees would currently prefer to hedge inflation rather than interest rates “because inflation actually affects benefit payments whereas interest rates do not”, according to Mark Davies, a managing director at investment consultancy P-Solve.
“Most schemes should have some interest rate hedging and some inflation hedging as, in the absence of this, the dominant investment risk the scheme is taking is a view on the liabilities alone.”
On the outlook for pension schemes, Jay Shah, co-head of business origination at PIC, said low interest rates, added to the likely effects of a loosening of the Bank of England’s strong focus on inflation targeting, could mean real yields will remain depressed for some time.
“This is not good news for pension fund trustees and their sponsors,” he said.
