A growing concern
Inflation is one of the key risks trustees need to be aware of, says Ceri Jones
Inflation is one of the largest current problems for pension scheme trustees, but it was not always so. Over the 20 years until 2010, the average inflation rate was 2.72%, while most commentators are now predicting inflation of around 2.5-3.0% for this year.
Over the longer term, the outlook for inflation over the next 15 years is that it will to average around 3% a year and 3.5% a year over the next 25 years.
It is a far cry from the dark days of the 1970s, when UK inflation averaged 13% a year, peaking at 25% in 1975. As a general rule, inflation generally rises in growing economies.
Periods of deflation – falling prices – are associated with economic uncertainty, such as the 1930s Depression and 1990s Japan.
A rapid expansion of the supply of money can also lead to inflation – the best examples being the hyperinflation experienced by the Weimar government in 1920s Germany and more recently in Zimbabwe.
WHY INFLATION MATTERS
Inflation rates are critical for UK pension schemes because higher rates raise the cost of pension provision.
Trustees of defined benefit funds are bound by law to increase pensions in payment, and deferred pensions, in line with inflation.
However, the liability is usually capped at 2.5% or 5%, depending on when benefits were accrued and whether or not the member is active or deferred.
Occasionally, if inflation is very high and exceeds the cap, that can help funds reduce their liabilities because returns from investments are likely to outpace the inflation limit. The relationship between inflation and the size of liabilities is complicated however, as the methodology on inflation-capping varies.
The worst that could happen to a pension fund is deflation, because pensions in payment and deferred pensions can never be reduced or returned to lower levels.
CPI v RPI
The chancellor announced a change to the way pensions are uprated in his June 2010 emergency budget, switching from the Retail Prices Index (RPI) to the Consumer Price Index (CPI), which came into effect last April.
This created huge opposition from the unions because CPI is known to rise by less than RPI on average (see graph).
In practice therefore, pensions in payment will either be linked to CPI or RPI, capped at 5%, with CPI largely adopted wherever RPI was not stipulated in the scheme’s Trust Deed & Rules.
In contrast, deferred pension revaluations are normally linked to statutory price revaluations, which now means CPI.
The National Association of Pension Funds estimates that some 80% of schemes are able to switch to CPI for the revaluation of deferred members.
An NAPF survey also revealed that 75% of schemes that can switch to CPI for pensions in payment will do so, with 25% undecided. The decision prompted the independent Office of Budget Responsibility to write a working paper on ‘The Long Run Differences between RPI and CPI’. RPI has historically been 0.7% higher than CPI but the consensus is that the difference will widen, to 1-1.25% a year.
The difference in CPI and RPI is largely a consequence of three factors:
■ Different formulas: Mathematically, CPI will almost always be less than RPI, particularly in highly volatile circumstances, as the two rates are based on different formulas.
■ Different baskets: RPI measures a different basket of goods, which includes mortgage interest payments, council tax, house depreciation, and household insurance.
Over the next 10 years mortgage payments are expected to rise, which is one of several reasons why RPI is likely to be the higher of the two measures. However, the Office for National Statistics is investigating whether mortgage interest may also be included in CPI.
■ Weightings: These have a significant impact – food prices make up just 10% of RPI, but 20% of CPI, for example.
Inflation changes over time. Analysts believe the current high levels of inflation will fall to 2.5-3% this year, close to the average rate of 2.72% over the past 20 years.
Schemes most often use index-linked gilts and swaps to hedge or reduce inflation risks and monitor both markets, shifting between the two to take advantage of the best available protection.
According to the Debt Management Office, which oversees the UK’s gilt issuance and market, there are £338.5bn of index linked gilts in circulation, compared to over £1trn of UK pension scheme liabilities.
Index linked gilts are pegged to RPI and there are currently no CPI-linked gilts available.
Although the DMO issued a consultation on this issue in summer 2011, it decided against issuing CPI linked gilts on the grounds of cost effectiveness and the current uncertainty over the makeup of CPI, but did not rule out issuing such gilts in the future.
As a result, most schemes use some kind of swap-based strategy to hedge inflation risk.
Swaps are a type of derivative contract whereby a scheme pays a fixed rate over the term of the agreement and receives the variable return on RPI from the counterparty – usually an investment bank. If inflation is above the agreed level in the swap, the scheme is effectively insured.
Swap contracts are seen as a cost effective way to gain a high level of protection, with transaction costs as low as 0.1%. There is consensus on how much of the liabilities should be hedged. Hedging the first 50% of liabilities is felt to be more economically beneficial than the second half, while being ‘fully’ hedged would typically mean protecting around 80% of liabilities, as the additional benefits of hedging diminish above this level.
Physical assets such as commodities and real estate are often viewed as providing inflation protection, and many schemes invest in buildings and other property with long-dated leases linked to a price index.
The income of utilities companies – water, gas, electricity – and other infrastructure assets normally includes a degree of inflation linkage. Further detail on the Coalition’s proposals to promote infrastructure investment among UK pension schemes is expected in the March budget.
RPI and CPI are structurally different, but may become more similar
REAL BOND YIELDS
Real bond yields are the return on bonds minus inflation. Non-index linked gilt yields are currently around 2%, while inflation is above 3%, meaning the return on bonds is negative. Partly this is because investors are buying bonds in a desperate bid for safety – unlike other assets, investors know they will get their money back from the UK government.
The perception of the UK as a safe lender has led to heavy inflows from foreign investors, while insurance companies and banks are under regulatory pressure to hold large amounts of ‘safe’ assets.
This decline in real yields has forced up the mark-to-market value of liabilities higher for all schemes and resulted in lower funding ratios for those with a low degree of hedging in place.
Pension consultants Redington estimate that approximately 80% of schemes have a hedge ratio of less than 50% and are likely to see a significant fall in their funding level.