RPI to CPI - Investment Implications

© 2010 The Actuarial Profession www.actuaries.org.uk

Robert Gardner, RedingtonJay Shah, Pension Corporation

Workshop session A:

RPI to CPI

Investment Implications

2 June 2011

The Inflation basket

1© 2010 The Actuarial Profession www.actuaries.org.uk

RPI:

+ Financial Services

What has happened


Legislative changes

Proposed switch in

statutory indexation:

RPI to CPI

Implementation

8 December 2010

Consultation

launched

8 July 2010 6 April 2011

RPI vs. CPI


Why it’s happened

-2

-1

0

1

2

3

4

5

6

Perc

en

tag

e

RPI (y/y) CPI (y/y)

• CPI is BoE’s

benchmark for the

whole economy

• Only 7% of

pensioners have

an outstanding

mortgage

1

2

3

Standard Deviation:

•RPI 1.54

•CPI 1.01

Source: ONS

• (Reduce public pension liabilities...)

How it’s happened


Public sector

• Pensions in payment increases indexed to CPI,

• capped at 5%

Private

• No mandatory statutory override

• No enabling modification power

• No CPI underpin required

• New pension consultation requirement

Risk managementUK inflation – the long run

Long run difference• Aggregate price changes

• Mathematical formula

• 2010 formula effect to persist

• Permanent 0.3% difference implied

• Long-run estimate of 1.2% “wedge”.


Formula effect

Source: ONS

Risk managementUK inflation - April 2011

• CPI jumped from

4% to 4.5%

• Above forecasts of

4.1%

• RPI fell from 5.3%

to 5.2%...


0

1

2

3

4

5

6

Perc

en

tag

e

RPI (y/y) CPI (y/y)

CPI up, RPI down

Source: ONS, Redington

Risk managementHedging inflation


-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

30y Swap Real Yield 30y Gilt Real Yield 30y Swap Spread (Swap Yield - Gilt Yield)

Finding relative value

Source: Bloomberg, Redington

Risk managementHedging inflation


Hedging CPI

Physical assets

• CPI-linked gilts?

• Flight Plan

Consistent Assets

(FPCA)

• CPI bond market...?

CPI

Reaction of schemes looking to de-risk

• How does this impact us?

– In payment : RPI generally hard-coded

– In deferment : reference to statutory revaluation

• ETVs and PIE exercises put on hold

• Buy-in / Buy-out decisions delayed


Now – business as normal


Column: Stack

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

2004 2005 2006 2007 2008 2009 2010

(£ million)Pension insurance

buyout / buy-in

Pension insurance buyout CAGR¹: 66%

Longevity insurance

Market growth maintained Transactions completed

Pension scheme view of CPI vs. RPI


RPI vs CPI Index: January 1988=100

75

100

125

150

175

200

225

1988

01

1989

01

1990

01

1991

01

1992

01

1993

01

1994

01

1995

01

1996

01

1997

01

1998

01

1999

01

2000

01

2001

01

2002

01

2003

01

2004

01

2005

01

2006

01

2007

01

2008

01

2009

01

2010

01

RPI rebased

CPI rebased

Insurer view of CPI vs. RPI


RPI vs CPI year on Year since 1989

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

1989

09

1990

09

1991

09

1992

09

1993

09

1994

09

1995

09

1996

09

1997

09

1998

09

1999

09

2000

09

2001

09

2002

09

2003

09

2004

09

2005

09

2006

09

2007

09

2008

09

2009

09

YoY % increase RPI

YoY % increase CPI

RPI vs. CPI – stochastic simulation – no underpin


Source: Barrie and Hibbert

RPI vs. CPI – stochastic simulation – with underpin!


Source: Barrie and Hibbert

Hedge with RPI

• 1 in 200 year test

• Basket of goods

• Methodology

• Political influence

• LPI (0,5) using CPI

• Annual vs compound


Hedge with CPI


• Investment Bank A : CPI vs RPI = 0.1%

• Investment Bank B : CPI v RPI = 0.2%

• Capacity available : Small

Instrument Approx market size

Indexed RPI gilts £270 bn

Indexed RPI bonds £30 bn

RPI Inflation swaps £100 bn

CPI linked Virtually nil

Insurer solutions

• Will insure on CPI but no discount to RPI

– Expected CPI under-run = cost of additional mismatch

risk capital

• Some insurers able to move from RPI to CPI in future

– In anticipation of CPI market opening up in future

– Part refund of premium

– To whom – scheme or company

– On a buy-in or buy-out?

• Differential pricing?

• Source CPI assets?


But general market movements more significant


• Affordability chart reflects approximate asset/liability mix of

the Scheme (c70% equities and 80% non-pensioners)

• Chart assumes scheme is fully funded initially – for an

underfunded scheme the volatility in the deficit will be much

larger

Our survey says...

© 2010 The Actuarial Profession www.actuaries.org.uk

Survey Results

1. What proportion of inflation-linked liabilities are matched

with inflation hedging assets such as index-linked gilts,

inflation swaps or buy-in insurance policies:


0%

10%

20%

30%

40%

50%

60%

70%

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

Proportion of matching assets

Survey Results

2. Broadly what proportion specify statutory minimum

revaluation/indexation, i.e. they could automatically move

to CPI:


0%

10%

20%

30%

40%

50%

60%

70%

< 25% 25% - 50% 50 - 75% >75%

Proportion of schemes

Revaluation in deferment Benefit indexation in payment

Survey Results

3. For those that could automatically move to CPI, what

proportion will move (or have actually moved) to CPI

(rather than retain RPI):


0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

< 25% 25% - 50% 50 - 75% >75%

Proportion of schemes

Revaluation in deferment Benefit indexation in payment

Survey Results

4. In your view is it fair that schemes that can move to CPI

should move to CPI?


Yes76%

No24%

Survey Results

5. What is your long term expectation for CPI inflation

relative to RPI inflation:


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

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

Survey Results

6. Of possible de-risking options, which of the following do

you think your schemes consider seriously over the next

3 years:


0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Buy-in or buy-out

Longevity swap Liability management

exercise

None Other

Unlikely Likely Almost certainly

Survey Results


6. Other:

“Growth asset reduction (and increased matching assets)”

“Changes to investment strategy”

“Reduce scheme benefits – cease accrual”

“Investment triggers”

“Dynamic de-risking using funding level triggers”

“LDI”

“Other asset strategies, e.g. contingent/asset backed

funding”

Survey Results


7. What impact has the CPI move had on schemes

considering de-risking?

“None”

“Funding level increase”

- put buy-in / buy-out back on the agenda

- speeded up growth asset de-risking

“Halted buy-in until market in CPI develops”

“Lack of CPI-linked instruments has made de-risking more difficult”

“Very little yet, many are still awaiting final legal advice on whether CPI

applies”

“Some are waiting for dust to settle before proceeding”

Questions or comments?


Jay Shah

• Co-Head of Business Origination

• Pension Corporation

• [email protected]

• Tel: + 44 20 7105 2111

Robert Gardner

• Co-Chief Executive

• Redington

• [email protected]

• Tel: + 44 20 7250 3416

In addition...

http://twitter.com/robertjgardner

http://uk.linkedin.com/in/robertjgardner

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RPI to CPI - Investment Implications

Economy & Finance