Inflation Hedging and the Change in Indexation from RPI to CPI - Survey Results

UK FINAL SALARY PENSION SCHEMES:

INFLATION HEDGING AND THE CHANGE IN INDEXATION

FROM RPI TO CPI

SURVEY RESULTS

DECEMBER 2011

www.redington.co.uk/www.pensioncorporation.com 1

Executive Summary

Redington and Pension Corporation conducted a survey of actuaries and trustees across the

UK over the period May to October 20111. Key findings and conclusions included:

The overwhelming majority of schemes are highly vulnerable to future inflation increases.

Less than 20% of defined benefit pension schemes covered in the survey had at least

50% of their inflation-linked pensions backed with inflation-linked assets such as index-

linked gilts. Thus, the majority of schemes are structurally underhedged and therefore

exposed to rising inflation.

This general inflation risk poses a much greater risk to most schemes than CPI/RPI

basis risk and the priority of these schemes should be to increase overall levels of

inflation protection.

64% of actuaries said that schemes they advised would “likely” or “almost certainly” carry

out a buy-out or buy-in over the next three years while 39% of trustees believed in this

outcome.

91% of trustees said they would “likely or almost certainly” consider better asset liability

matching over the same period.

Commenting on the results, Robert Gardner of Redington said: “The switch in statutory

indexation from RPI to CPI has impacted schemes looking to de-risk, but, taking stock of

their current standing point, fundamentally pension schemes can do a significant amount of

first order inflation de-risking using RPI before they need to worry about second order

RPI/CPI basis risk”.

Jay Shah of Pension Corporation added: "Pension schemes are continuing to take big risks

of inflation eroding away investment returns and funding positions deteriorating. So it is good

news that de-risking is now at the top of the agenda. However, trustees should look at how

they can best remove risk from their scheme, even if they aren't able to insure, given current

funding levels”

This paper discusses the impact of the CPI/RPI split and general views of the industry based

on the survey results of Redington and Pension Corporation. Section 2 discusses recent

legislative changes with respect to statutory indexation of UK pensions while Section 3

outlines the key factors driving the spread between CPI and RPI and perspectives on the

future size of this spread. This has important implications for investment strategy as a wider

spread implies greater basis risk for schemes that hedge CPI-linked liabilities with RPI-linked

assets. Section 4 considers the investment instruments available for schemes to hedge CPI

inflation. As this market is currently limited and expensive, the paper also considers possible

alternatives that may become available in coming years. The final section assesses current

levels of inflation hedging and respondents’ views on future hedging strategies.

Each section integrates a general discussion of the topic with relevant results from the

survey.

1 A total of 89 actuaries and 23 trustees were surveyed.

Note: Some participants did not respond to every question in the survey.


Table of Contents

1. INTRODUCTION ............................................................................................................. 3

2. LEGISLATIVE CHANGES .............................................................................................. 4

3. RISK MANAGEMENT: UK INFLATION ......................................................................... 7

4. RISK MANAGEMENT: HEDGING INFLATION ........................................................... 10

5. RISK MANAGEMENT: CURRENT HEDGING LEVELS .............................................. 12

6. CONCLUSION .............................................................................................................. 15


1. Introduction

The inflation basket

UK inflation is measured against a basket of goods ranging from cars and transport costs to

food, clothes and alcohol. This is reviewed on a yearly basis with 2011 seeing the inclusion

of apps and smart phone handsets while less popular items such as “spectacles without

lenses” were adjusted or removed2.

The UK has two primary indices for measuring inflation:

Retail Price Index (RPI)

Consumer Price Index (CPI)

There are three main differences between the two measures:

Coverage (the actual goods and services included in the indices):

Most significantly, housing costs are included in RPI but not CPI.

Population base:

For example, RPI excludes higher earners and pensioner households dependent

mainly on State benefits whereas CPI includes these as well as institutional

households such as nursing homes.

Index construction formula:

The RPI is constructed using an arithmetic mean while the CPI is constructed using a

geometric mean.

Section 3 discusses these differences and their contribution to CPI/RPI basis risk in more

detail.

2 Consumer prices Index and Retail Prices Index: The 2011 Basket of Goods and Services, ONS


2. Legislative Changes

On 8 July 2010, the Minister of State for the Department of Work and Pensions (DWP),

Steve Webb announced the Government’s intention to move to using CPI as the measure of

price inflation used to determine statutory increases to pensions in payment. The proposed

changes were to affect how deferred pensions are revalued in the future, and how pensions

in payment are increased. Speaking at the National Association of Pension Funds (NAPF)

conference, Webb said CPI was the government’s favoured measure for two reasons:

1. The Bank of England defines price stability in terms of CPI and it serves as their

inflation target.

2. CPI excludes mortgage costs. As only 7% of pensioners have mortgage payments

outstanding, CPI provides a fairer and more accurate picture of the cost of living

facing pensioners.3

Not mentioned by Webb was the reduction in public pension liabilities - estimated by the

DWP at £73bn - that will be achieved as a result of the switch.4

On 8 December 2010, the DWP launched a public consultation on the switch. While public

sector schemes are subject to the “statutory minimum” requirement for revaluation and

indexation, the possibility of a mandatory statutory override was raised for private sector

schemes. This would have automatically shifted indexation to CPI even in schemes where

RPI has been explicitly cited or “hardwired” in pension contracts. After public protests

against this suggestion, the final changes implemented on 6 April 2011 were as follows:

Public sector schemes:

Pensions in payment increases indexed to CPI

Caps at 5% and floors at 0%

Private sector schemes:

No mandatory statutory override – legislation will not be introduced to directly

override a pension scheme’s own rules without the consent of trustees or employers.

No enabling modification power – where a scheme’s rules explicitly specify RPI,

legislation will not be introduced to make it easier for a scheme to switch to CPI.

No CPI underpin required – schemes providing RPI increases will not need to also

provide a CPI underpin (i.e. where CPI is higher than RPI in a given year).

New pension consultation requirement - employers of schemes making amendments

will need to consult on these changes for at least 60 days.

While overriding powers were not granted, pension scheme rules varied such that the new

legislation gave some schemes (those that specify “statutory minimum” indexation) the

ability to switch to CPI while others remained pegged to RPI in what some industry members

have termed the “small print lottery”.

3 Households Below Average Income, An analysis of the income distribution 1994/95 – 2008/2009, DWP

4 Pensions Act 2011 Impact Assessments Summary, July 2011, Department for Work and Pensions


On 2 December, the High Court rejected a lawsuit brought by six trade unions against the

statutory switch. The judgement acknowledged that deficit reduction had been the

government’s main motivation but rejected the unions’ argument that the enlistment of RPI in

the past constituted an implicit promise of its continued use. The unions have since pledged

to take the case to European courts.

Survey Results

In considering whether it would be fair for those schemes that can move to CPI to

subsequently do so, there were contrasting opinions between actuaries and trustees in our

survey. Over 70% of actuaries surveyed believed that it would be “fair” for schemes to enact

a switch while 70% of trustees disagreed.

Fig 1. To Actuaries and Trustees: In your view is it fair that schemes that can move to CPI

do so?

Source: Redington, Pension Corporation, based on responses from 85 actuaries and 23 trustees

Consensus from the survey has been that revaluations would largely occur for benefits in

deferment. In general, where “statutory minimum” has been specified, most schemes would

move to CPI.

0%

10%

20%

30%

40%

50%

60%

70%

80%

Yes No

Actuaries Trustees


Fig 2. To Trustees: Does your scheme specify statutory minimum revaluation / indexation,

i.e. could the scheme automatically move to CPI?

Source: Redington, Pension Corporation, based on responses from 20 trustees

Fig 3. To Trustees: Will your scheme move to CPI?

Source: Redington, Pension Corporation, based on responses from 20 trustees

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Yes No

"Statutory minimum" specified

Revaluation in deferment Benefit indexation in payment

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Yes No

Move to statutory minimum

Revaluation in deferment Benefit indexation in payment


3. Risk Management: UK Inflation

Long run difference

There are fundamental differences between RPI and CPI as inflation measures:

Aggregate price changes - coverage

The indices were intended to reflect different populations. RPI includes housing

costs such as mortgage interest payments, housing depreciation and council tax.

However, it excludes spending by the top 4% of households and by low income

pensioners on state benefits. In this way, it was supposed to be reflective of the

typical UK household.

CPI aims to cover the spending of the broader population, and is based on the

expenditure of all private households in the UK plus overseas visitors and residents

of nursing homes, retirement homes and university halls. Both indices notionally

cover a basket of goods and services compiled essentially from the same basic

information of individual prices. However, the difference in components and item

weightings within the indices means that different factors affect the respective

inflation rates and their volatility.

Mathematical formula

RPI is based on an arithmetic mean while CPI is based on a geometric mean. The

technical differences in the way the indices are calculated (fig 4.) mean that, with all

things being equal (i.e. same items and weightings), RPI will be higher than CPI. The

difference between RPI and CPI arising from this formula effect has risen from

around 0.5% in 2009 to around 1% in 20115 (fig 5). The ONS has indicated that

changes in the way in which prices of clothing are measured, first implemented in

January 2010, were responsible for this increase6.

Fig 4. Numerical Example- Arithmetic vs. Geometric Mean

Assume 3 different items are covered by both CPI and RPI: Food (prices up 3%),

Energy (prices up 6%) and Retail (prices up 1%)

= 2.15%

Mathematically, the difference between an arithmetic and a geometric mean

increases with the variation in the size of the inputs (“dispersion”).

5 A breakdown of the differences between CPI and RPI, August 2011, ONS

6 CPI and RPI: increased impact of the formula effect in 2010, ONS


Fig. 5. A breakdown of the difference between CPI and RPI: formula effect

Source: ONS

The government’s economic and fiscal outlook for 2011 assumes that the recent widening of

the gap between RPI and CPI inflation due to the formula effect will persist. If mortgage

interest payments grow in line with average earnings growth, the spread is expected to be

around 1.2% in the long run. However, according to central forecasts, mortgage interest

payments will rise faster than average earnings, so the spread would, in reality, be larger

than the implied 1.2%7.

Short-term trends have pointed in the opposite direction. Since April 2010, the gap between

CPI and RPI inflation has narrowed from 1.6% to just 0.4% in October 2011. The ONS

attributes this to the impact of falling mortgage costs, which has limited the rise in RPI. CPI

has risen from 3.7% to 5% over the period while RPI has edged up slightly to 5.4% from

5.3%.

Fig 6: Current Inflation

Source: Redington, ONS

7 Economic and fiscal outlook, March 2011, Office for Budget Responsibility

0.00

0.20

0.40

0.60

0.80

1.00

1.20

%

0

1

2

3

4

5

6

%

RPI (y/y)

CPI (y/y)


The BoE predicts that inflation will fall sharply over the next year, with CPI forecast to decline

below 2% by the end of 2012. Conversely, the CPI/RPI spread could become more pertinent

to many schemes in the context of waning inflation. For those that cap inflation increases,

the effective spread- that is, the actual impact on pension increases from the legislative

changes, falls to zero when both CPI and RPI exceed the cap but rises when either measure

dips below it.

Survey Results

In our survey, 67% of actuaries and 74% of trustees expect the long-run difference between

the two measures to fall between 0.5% and 1%.

Fig.7. To Actuaries and Trustees: What is your long-term expectation for CPI inflation

relative to RPI inflation?

Source: Redington, Pension Corporation, based on responses from 89 Actuaries and 23 Trustees

These views have important implications for investment strategy as a wider spread implies

greater basis risk for schemes that hedge CPI-linked liabilities with RPI-linked assets. The

following section explores the hedging opportunities available to schemes looking to address

this risk.

0% 10% 20% 30% 40% 50% 60% 70% 80%

Same as RPI

c.0.5% p.a. less than RPI

c.0.5% to 1% p.a. less than RPI

1% to 2% less than RPI

Actuaries Trustees


4. Risk Management: Hedging Inflation

Given that RPI has historically been the national benchmark for inflation, there is

unsurprisingly a well-established market in RPI hedging products. All past and current

issuance of UK government inflation-linked debt is indexed to RPI and schemes also have

access to a liquid market in RPI-linked swaps. In contrast, the market for hedging CPI

inflation is in its infancy and is far more limited.

CPI Swaps

Although a CPI swap market has recently developed, there is virtually no availability and

transaction costs are high. Bid-offer spreads quoted by banks on 20 and 30-year CPI swaps

tend to be around 20 basis points compared to just 5 basis points for RPI swaps of the same

maturities.

One might also note that 20 and 30-year inflation swaps are pricing in a spread of around

0.47% between CPI and RPI inflation. Thus, after allowing for the spread and assuming

availability, the implied market rate is perhaps 20-30bps. This offers a lower hedge than both

the long-run gap expected by most respondents to our survey and the average gap of 0.87%

prevailing from May 1997 to October 2011.

CPI-linked Gilts

In July 2011, the Debt Management Office (DMO) launched a consultation to gauge the level

of demand for CPI-linked Gilts in light of the proposed shift from RPI to CPI. Some

respondents expressed concern that their introduction would cause market fragmentation,

which would damage liquidity and pricing for both CPI and RPI-linked securities.

DMO Chief Executive Robert Stheetham has acknowledged that some fragmentation would

be “inevitable” but said this would not be the DMO’s overriding criteria in deciding whether or

not to issue the bonds8. It is worth noting that the French index-linked market has both

French and European HICP-linked issuance, and both markets are liquid.

In their response to the DMO consultation, industry bodies including the Society of Pension

Consultants and Association of Consulting Actuaries suggested that any new CPI-linked

issues be concentrated at shorter durations. This reflects the view of respondents to our

survey that revaluations would largely occur for benefits in deferment while pensions in

payment will remain predominantly linked to RPI.9

On 29th November 2011, the DMO announced that it would not be issuing CPI-linked Gilts in

2012/2013. Factors cited in the decision included uncertainty around the future composition

of the Consumer Price Index, market fragmentation and the depth and sustainability of CPI-

linked Gilt demand. Although it has been stressed that the decision would not preclude CPI-

linked issuance in the medium term, this highlights the uncertainty in the development of the

CPI market and the availability of hedging instruments in the near-term.

8 Life and Pension Risk, September 2011

9 Professional Pensions, October 2011


Flight Plan Consistent Assets

“Flight Plan Consistent Assets” (FPCAs) offer an alternative means for schemes to hedge

inflation risk and could potentially enable schemes to access CPI-linked cash flows. FPCAs

provide secure, long-dated, inflation-linked cash flows which are therefore a good match for

pension liabilities. Moreover, their illiquid nature means that they tend to deliver higher real

returns than traditional matching assets, such as government bonds due to the additional

‘illiquidity premium’.

Examples of FPCAs include secured leases, social housing, and infrastructure investments.

Given their combination of higher real returns and liability-matching properties, these assets

can be thought of as lying on the spectrum between traditional return seeking (growth) and

matching asset classes. As a result of having a blend of qualities not neatly fitting in

conventional “buckets”, they have tended to be overlooked by many pension schemes.

Investment in FPCAs also tends to be more complex with a wide variety of risk/return

profiles and investment structures available depending on the asset.

FPCAs can be expected to grow in prominence in light of the government’s desire to

strengthen the UK’s ailing infrastructure and boost economic growth in the process. As part

of his Autumn Budget Statement on 29 November, Chancellor George Osborne announced

a new £30bn National Infrastructure Plan including new toll roads and railway projects.

Treasury Secretary Danny Alexander said that “unlocking pension fund money” was an

explicit goal of the project and the government expects schemes to finance around two-

thirds of the total. Details on the investment structure are still to be determined and will affect

the extent of inflation hedging accessible to schemes through the new fund. If the fund

issues inflation-linked debt, any link is likely to be to RPI to reflect the underlying cash flows

of the projects (UK toll fees and rail fares are typically linked to RPI).

Although not mentioned in the Autumn Statement, commentators have suggested that social

housing could be a potential beneficiary of the new £30bn fund. For schemes seeking a

direct CPI hedge, these projects could provide one source of supply. The government

recently mandated that social housing rental payments be increased in line with CPI from

2013 onwards. Housing associations therefore have an incentive to finance future projects

with CPI-linked debt that matches their contractual income. However, their ability to do so

could depend significantly on the development of a liquid market in CPI-linked Gilts. The

latter could be expected to boost investor demand for other CPI-linked securities by

providing a transparent and reliable means to price such assets.


5. Risk Management: Current Hedging Levels

Survey Results

The prospect of rising CPI/RPI basis risk with limited instruments available to access CPI-

linked assets is an unsettling conclusion for pension schemes. However, it is important to

consider this issue in the context of schemes’ current levels of inflation hedging. The results

of our survey show that in total, only around 16% of participating schemes had 50% or more

inflation-linked assets matching their liabilities. Thus, for the majority of schemes, the relative

risk arising from hedging CPI-linked liabilities with RPI-linked assets will be small versus

overall inflation risk.

Fig.8. To Actuaries and Trustees: What proportion of inflation-linked liabilities are matched

with inflation-hedging assets such as index-linked gilts, inflation swaps or buy-in insurance

policies?


These findings suggest that, for most schemes, overall de-risking should be the first order

objective. On this score, the results of our survey provide some cause for optimism. 91% of

trustees said they would “likely” or “almost” certainly consider better asset liability matching

over the next 3 years.

0%

10%

20%

30%

40%

50%

60%

70%

0% - 25% 25% - 50% 50% - 75% 75% - 100%

Proportion of matching assets

Actuaries Trustees


Fig.9a. To Trustees: Of possible de-risking options, which of the following do you think your

schemes will consider seriously over the next 3 years?

Source: Redington, Pension Corporation, based on responses from 21 Trustees

66% of actuaries and 55% of trustees said their schemes would “likely” or “almost certainly”

consider a liability management exercise10 over the next 3 years.

Fig 9b. To Actuaries and Trustees: Of possible de-risking options, which of the following do

you think your schemes will consider seriously over the next 3 years?


10

Enhanced transfer value or pension increase

0%

10%

20%

30%

40%

50%

60%

Unlikely Likely Almost certainly

Better Asset Liability matching

0%

10%

20%

30%

40%

50%


Liability Management Exercise

Actuaries Trustees


There was less consensus on the issue of buy-ins/buy-outs with 64% of actuaries saying

their schemes would “likely” or “almost certainly” carry these out compared to 39% of

trustees. Finally, 17% of actuaries and 29% trustees said they would likely or almost

certainly consider a longevity swap.

Fig 9c. To Actuaries and Trustees: Of possible de-risking options, which of the following do



Fig 9d. To Actuaries and Trustees: Of possible de-risking options, which of the following do



0%

10%

20%

30%

40%

50%

60%

70%


Buy-in/Buy-out

Actuaries Trustees

0%

20%

40%

60%

80%

100%


Longevity Swap

Actuaries Trustees


6. Conclusion

The switch in statutory indexation from RPI to CPI presents new challenges for UK pension

schemes. Schemes are exposed to the “small print lottery” in which apparently minor

variations in the wording of scheme rules could have important implications for the size of

pension deficits. Furthermore, the current market for hedging CPI inflation is characterised

by high transaction costs and a scarcity of available instruments.

However, while there are sound reasons to be concerned about CPI/RPI basis risk, it is

important to note that most schemes remain structurally underhedged against inflation risk

more generally. Thus, rather than paying undue attention to the nuances of obtaining CPI

protection, schemes could achieve a significant amount of de-risking merely by boosting

their overall allocations to inflation-matching assets. Notwithstanding the problems posed by

the statutory switch, addressing this first-order problem should be top of the agenda for most

schemes.

© Redington Limited and Pension Corporation LLP 2011. All rights reserved. No reproduction, copy,

transmission or translation of this publication may be made without the status of Redington Limited

and Pension Corporation LLP as the authors being acknowledged.

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Inflation Hedging and the Change in Indexation from RPI to CPI - Survey Results

Economy & Finance