Are UK schemes rushing too quickly into inflation hedging solutions?

Whichever way you phrase it, inflation is probably the major financial issue of 2011 in the UK, threatening people's lifestyles, the fragile state of the economy and of course, pension funds' liabilities.

Concerned funds thought they had solved the problem a while back by buying Retail Price Index-linked (RPI) gilts and swaps, but with the Government pushing many defined benefit (DB) scheme benefit rises to be linked to the Consumer Price Index (CPI), a new front in the battle against inflation has opened up.

CPI-linked gilts are being touted as a solution to the inflationary threat, with the small print of the 2011 UK Budget appearing to clear the path for the Government to begin issuing bonds that are linked to the newly-favoured inflation index later this year via the Debt Management Office.

The National Association of Pension Funds (NAPF), along with several investment managers and insurance firms have been advocating the issuance of the gilts so that schemes moving to CPI can match their liabilities, while some talk of funds who have existing RPI hedges wanting to unwind them, given the long-term difference that the few percentage points between the two indices makes.

But the new tool to tackle pension funds' inflation worries may not be a panacea.

Take the issue of liquidity in the current RPI inflation-linked bond market, which has long caused problems of supplying enough bonds to mitigate inflation risk. As BDO Investment Management investment director Matthew Phillips told Pension Funds Insider, a thin market with not a lot of issuance is not going to suddenly meet demand when it is plainly not in the government's interest to inflation-link much of its debt and make repaying it more expensive in real terms.

The net result of this is that government bonds are historically expensive, and should CPI gilts be issued, Phillips reckons that "demand for them could be at the expense of current RPI gilts". With pension funds sitting on a large share of the debt currently in circulation, Pensions Minister Steve Webb's announcement last July that pension liabilities would be encouraged to switch to CPI provoked a 4% drop in the value of benchmark 2055 RPI-linked gilts.

Sinead Leahy, head of UK pensions solutions at the Royal Bank Of Scotland said at last month's NAPF Investment Conference in Edinburgh that CPI swaps could also become a viable hedging possibility, but pension funds wanting to purchase such assets would have to make their voices heard on the matter.

Independent pension consultant John Ralfe has questioned where this demand will emerge from, however. He cited government figures to Pension Funds Insider that show only 20% of schemes, mainly at the smaller end of the spectrum, will be able to switch their pensions to a CPI linkage.

Ralfe also says that amongst this minority "any schemes continuing to hold substantial equities should not be concerned about small RPI-CPI differentials, which would also be pretty well covered by any existing RPI hedging." Branding the supposed need to remove CPI exposure "a storm in a teacup," Ralfe alleges that many people are advocating use of the new gilts in order to make money, not to deliver a public service.

Other hedges

With the signs pointing to a possible issuance of CPI gilts later this year, pension funds needing to match CPI liabilities may themselves have the opportunity to weigh up their value in due course.

There are other ways to get around the problem without succumbing to CPI panic. For instance, schemes that have already taken out RPI hedging in the form of RPI-linked gilts may be able to take the relatively straightforward path of selling of a share of these gilts to cover their exposure to the lower CPI index.

Schemes who have only partially covered inflation risk may be rightfully concerned at bigger long-term inflation projections and alternative assets are also presented as a way to manage this risk. Robert Gardner, a founder of consultancy firm Redington, claims that there are many opportunities in the likes of public-housing and public-private partnerships that offer returns related to CPI, saying: "There are lots of projects that offer long-term, inflation-linked, annuity-like income structured as CPI. The added benefit is that it provides infrastructure for future generations."

But Leahy points out that such asset classes are not easy for all pension funds to get into. "We need to make sure that there is a large wholesale market that all pension funds can access," she says.

As for CPI swaps, even as a potential seller of these Leahy concedes that pricing is currently unattractive for funds, although she foresees a CPI bond market prompting demand, saying: "CPI swap prices exist already but they have very wide bid-offer spreads, you can only transact in small size and quite frankly there is no liquidity. I wouldn't call it a swap market and it won't be active until we have the development of an underlying CPI bond market and the government starts to issue."

In any case, others see simpler solutions. Phillips views equities as offering plenty of long-term inflation-beating potential, saying that despite current macroeconomic uncertainty in European debt and high oil prices "there are quality companies out there who have come out of the crisis in rude health and with good cash holdings that can produce a pretty good return over the longer term".

For Ralfe, trustees and sponsoring companies would be better off concentrating on the more traditional issue in portfolio management of matching pension liabilities with a mix of fixed and inflation linked bonds, rather than worrying if their RPI bonds match CPI inflation risk.

"Hedging CPI just doesn't keep trustees awake at night," he says.

dbillingham@wilmington.co.uk

First published 05.04.2011