Protecting members’ benefits from inflation leads to added complexity for pension schemes, even with the RPI-CPI debate closed (for now).
UK Pension funds and inflation
UK defined-benefit pension funds tend to have liabilities linked to inflation, due to the contractual revaluation of benefit payments for active and deferred members each year, and the annual increases granted on pensions in payment.
Historically this risk exposure to (rising) inflation, and inflation expectations, was one of the largest risks facing pension funds, which has over time led pension funds more and more to consider investing in assets linked to inflation in order to best hedge this risk.
Enter the inflation caps and floors
When a pension fund starts to build a hedge for its liabilities it quickly discovers a subtle but important feature of its liabilities - while inflation itself can (and has) been negative from one year to the next, in a lot of cases the pension benefits that are paid out cannot decrease from one year to the next.
In the language of the capital markets, the benefits contain inflation floors at 0%. Most also contain caps at 3% or 5%.
Why caps and floors complicate the hedging process
The presence of the caps and floors changes the behaviour of the true market valuation of the liabilities, compared to a situation where they are not present. The theories relating to option pricing help us understand how, but the key outcome is that the change in value of the liability will not be quite “one-for-one” with changes in inflation, but somewhat less than one.
As a pension fund begins to build an inflation hedge from scratch, this level of detail is not paramount – the most important thing is acquiring more inflation hedging assets.
As the hedge becomes larger, and begins to approach (in percentage terms) the scheme’s funding ratio, it becomes important to take this effect into account. Typically pension schemes have three alternatives:
(1) Invest in instruments which exactly match the behaviour of the inflation floors (“LPI” swaps)
(2) Only invest in “pure” inflation linked instruments and accept the mismatch between that and the liabilities
(3) Only invest in “pure” inflation linked instruments, and attempt to match the behaviour of the caps and floors – this is often the most popular approach, but requires careful modelling of inflation caps and floors, and hence inflation volatility.
While the cost of instruments that precisely match the liabilities has fallen recently, there remains a substantial difference between the implied volatility of the inflation floors, and the realised volatility of the expected inflation rate which schemes can continue to benefit from by using a dynamic hedging approach to the inflation risk in their liabilities.
Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer