(January 10, 2013) — Pension funds in the United Kingdom that have not yet hedged their inflation exposure face higher costs to swap out the risk as expected changes to the measurement of price fluctuations were sidestepped by the overseeing authorities.
The Office for National Statistics (ONS) announced this morning that there would be no change to the calculation of the Retail Price Index (RPI), which most pension funds in the UK use as a measurement of inflation. It had been widely expected there would be a change in the calculation that would bring it closer into line with the Consumer Price Index (CPI) which has historically risen more slowly.
Pension funds that were holding out in the hope of hedging their inflation risk at a lower rate may have missed out.
As markets opened in London, one hour after the announcement, government-backed inflation-linked bonds rallied. The yield on a 10 year index-linked bond fell to a record low, according to figures from Bloomberg, making it more expensive hedge out the risk.
“Those who were deferring any further inflation hedging until after the announcement may feel that they have missed out on an opportunity to hedge while linkers were “cheap”,” said Crispin Lace, director of investment consulting at Russell Investments. “However, we caution against any precipitous action as markets may well settle down over the next few weeks as the longer term impact becomes clearer. As it stands today though, there seems little prospect of relief from negative real yields and pension funds may need to take a good hard look at the alternatives for hedging inflation.”
For pension funds, and other investors, who already held these securities, the picture was happier, however. “It is good news for investors with existing index-linked gilts, as any change could have adversely affected the value of these investments,” said Paul Sweeting, European head of strategy at JP Morgan Asset Management. “The lack of any change for index-linked gilts is understandable – changing the index for existing investors would have essentially changed the terms of the investments.”
The announcement was also good news for pension fund members whose benefits are linked to RPI as they should see no reduction in benefit as a result of today’s announcement. Following a decision by the UK government in 2010 to switch certain public sector workers’ entitlements to link to CPI, many private sector pension funds followed suit, thereby significantly reducing their liabilities. This trend has abated recently however although some may have been waiting for today’s decision, which could have had a similar effect on obligations.
The question of inflation-hedging remains for pension funds, but there are options outside the gilt market.
Even before today’s announcement, the demand for inflation-linked bonds outstripped supply. Figures from investment consultant Redington show issuance has quadrupled since 2005. Inflation-linked bonds in issuance amount to £235 billion, with roughly £200 billion in inflation-linked gilts and £35 billion of corporate issuance.
Robert Gardner, co-CEO at Redington, said: “The inflation-linked market growth is not enough to match the inflation-linked part of the £1,200 billion UK pension schemes’ liabilities. This mismatch between demand and supply is not likely to revert soon, pushing the real yield at the long-end lower.”
Gardner said: “In order to avoid this shortage of supply, pension schemes should compare index-linked gilts opportunities to other solutions available in the Liability Driven Investment space. There are often other ways to hedge inflation risk at a lower cost and still benefit from credit and illiquidity premia.”
For the announcement from the ONS, click here.