Switching ratios

Once lawyers have pored over a scheme’s rules and established the extent to which the statutory shift to consumer prices index (CPI) inflation will affect its liabilities, the complicated task of devising an efficient investment strategy to meet those new targets begins.

As the retail prices index (RPI) has been the standard measure of inflation in the UK for more than 70 years, a vast liquid market of RPI-linked gilts, as well as some corporate issuance, has become established. The statutory shift to CPI created the demand for similar CPI-linked instruments – but was not accompanied by the creation of supply.

Phil Page, client manager, Cardano says: “The market for hedging RPI inflation is pretty developed with two main sources, inflation swaps and index-linked gilts, as well as, to a lesser extent, index-linked corporate bonds. The sources for hedging CPI inflation are practically non-existent.”

The problem likewise applies to liability driven investment (LDI) strategies. Says Richard Butcher, managing director, Pitmans Trustees: “We have got to change those LDI strategies, but there is no tool that we can use. It creates an element of mismatch in a strategy that is impossible to quantify.”

The investment challenge resulting from the shift from RPI to CPI may sound like a small change. But changing the measure of long-term inflation by just the average difference between the measures is equivalent to a profound shift in investment markets. For a pension scheme, with 60% in equities and 40% in gilts, a rise in 30-year inflation expectations from 3% to 3.7% roughly equates to a 30% drop in the FTSE 100, from 6,000 to 4,200. As Ben Clissold, deputy-CIO of P-Solve, notes: “It is just as serious but the stock market would be on the front page of the Financial Times.”

Moving target

The DWP has estimated (see diagram, left) that schemes will be affected in a variety of ways depending on their rules. The most common outcome, affecting 60% of schemes, is for deferreds to be indexed to CPI and for pensions in payment to continue to be linked to RPI.

Pension schemes need to spend time looking at how the legislation impacts their scheme rules,” says Sinead Leahy, head of UK pension solutions, Royal Bank of Scotland. “Does it affect all their members, or just pension increases? Overall we estimate for UK private sector pension funds that 40% of inflation linkage will be to CPI. The question is: what should pension funds do to match this risk?”

The calculation is complicated by the trend for actuaries to ‘mark to market’ when estimating liabilities. Actuaries can derive the market view of RPI from the yield curve of RPI-linked gilts – as there is no equivalent CPI-linked market actuaries must form their own ‘best estimate’, which will vary from scheme to scheme.

CPI is different from RPI in two fundamental ways. RPI is constructed by adding price changes of a sample of goods (an arithmetic mean) and it contains housing costs such as mortgage repayments. The construction of CPI factors in demand for a good decreasing as its price relatively increases (a geometric mean) and excludes housing costs. On average over the last 20 years, CPI has been around 0.7% lower than RPI.

While historically CPI has been below RPI on average, in five out of the last 20 years CPI has bobbed above RPI. Likewise, RPI can be higher than CPI by significantly more than the long term average.

Gwion Moore, head of investment strategy UK at Mn Services, a fiduciary manager, says that many commentators “have underestimated the likely future difference between RPI and CPI, and so underestimated the reduction in pension benefits that will result.”

The difference due to their differing construction is stable over time, at around 0.3% to 0.4%. But the housing component is volatile and is likely to make the difference larger over the next few years. As Clissold explains: “In a rising rate environment, which is likely over the next five years, the difference tends to be larger. This is because interest payments on mortgages are included in RPI but not CPI.”

At the moment we have exceptionally low short term interest rates – the base rate is 0.5% compared with 5.75% shortly before the crisis. One should note that the recent 0.7% average difference encompassed a period of sustained falling mortgage costs. Says Page: “When interest rates rise, the difference might move out to 0.8-0.9%. That is one of the hardest factors to hedge.”

The difference between CPI and RPI is also subject to tinkering by the authorities. CPI was originally devised to harmonise inflation in the eurozone but ultimately adopted wholesale by the UK. The EU is now starting to talk about including some input from housing costs, which would bring it closer to RPI.

Shift to CPI linkers?

In theory, the simplest way of hedging CPI would be to buy CPI-linked bonds – but this market simply does not exist. “The introduction of CPI [adds] complexity to the investment space,” says Charles Marandu, director of European advice at SEI. “The current lack of liquid inflation bonds and swaps referenced to CPI brings risk of mismatch if the trustees of a CPI-linked scheme hedge their liabilities using RPI instruments.”

The only way of hedging CPI is by buying a CPI-linked swap from a bank. But as Clissold says: “Any bank will offer you a CPI swap but the price is wrong – nothing like value for money for pension schemes.”

A 15-year RPI inflation swap currently costs 3.5% (ie the scheme pays 3.5%, the bank returns RPI) whereas a CPI swap costs around 3.25%. Says Page: “The overall result is that you are significantly overpaying for CPI protection in the inflation swap market.”

This poor value will not be enough to put off some pension schemes, according to Clissold: “There will be pension schemes – there always are – that will be dazzled by the lights and persuaded into doing something that is not in their best interests by their advisors or a bank and they will hedge CPI at the wrong price.”

Leahy, of bank RBS that offers CPI swaps, advises that transaction costs are currently high and she does not recommend schemes to go down this route. “We can offer prices for CPI swaps but it is not yet a tradable, liquid market. We say that schemes should focus on the current liquid markets in RPI-linked bonds and inflation swaps and use those as a proxy for CPI.”

Synthetic products

With their traditional routes cut off, schemes may be tempted to seek out structured products, if and when they start to appear. Says Butcher: “I am sure that it is not beyond the wit of some of the brains at the banks to come up with a range of futures and options that will provide a CPI-type return.”

Says Mn Services’ Moore: “It is relatively easy to create moderately effective hedges of the difference between CPI and RPI using existing market tools, and as a result we should expect to see ‘off-the-shelf’ CPI swaps offered by banks and brokers. However in the absence of primary marketing CPI securities, these are likely to have substantial bid-offer spreads. “Pension schemes will then be faced with a choice between more costly CPI swaps and cheaper approximate ‘do-it-yourself’ CPI hedges. The relative costs will need to be assessed in terms of the overall risks of the scheme’s investment objectives.”

As housing costs is the most problematic component, this market is the most obvious source for a derivative. Derivatives are already traded on the Halifax house price index to capture future movements. However, it is housing costs, not house price changes, that feed into RPI and the relationship between them is not stable – mortgage costs could increase with house prices, or cause them to fall.

Alternatively, one could purchase an RPI inflation swap and a fixed-interest swap based on the base rate that varies depending on when mortgage rates are rising or falling. But this is a pretty imprecise and high cost way of hedging, says Page: “Mortgage rates are driven not only by the base rate but also the mortgage provider’s margin. It is a big variable [currently 2.5%] that is not accounted for.” This margin has expanded hugely since the crisis started and remains an unknown quantity.

Another possibility is for schemes to invest in property with rent increases linked to CPI, either directly or by purchasing loans that investment banks have made to property owners. At the moment there are no deals and there are unlikely to be any in the private sector, says Page: “We need property owners to negotiate CPI rent reviews rather than RPI – but why on earth would they do so?”

The real opportunity lies in social housing, where the Government mandates CPI rent increases. Butcher notes that one social housing client has £1.5bn of unencumbered property and that social housing organisations, in general, believe they are set to grow.

“Shared ownership deals could be a significant source of debt,” says Butcher. “They could start issuing CPI debt that matches their contractual rental income. It is low risk to them and attractive to the market, so they could generate a good price.”

However, Page disagrees about the size of the opportunity: “The total size of the projects is very small. UK private sector pension funds have £700bn of inflation-related liabilities, of which perhaps 20% will become CPI-linked, so £140bn. Social housing projects might fill £5bn of that over a long period of time.”

Leahy notes that most of the supply of inflation-linked bonds comes from the Government and most of the issuance from the private sector was from PFI projects and long-dated property-linked transactions which have dried up: “We are currently not seeing the same level of inflation-linked private supply which reached its peak in 2007.” It is uncertain whether the Government’s fiscal position will cause it to increase reliance on private investment in public works or cancel them completely.

The demand from pension funds may also, or alternatively, spur private companies into issuing into this attractively-priced market. “The banks will now try and create supply – by speaking to RPI-linked issuers and convincing them to release CPI-linked debt,” predicts Clissold. “There will be such demand from pension schemes that it is well worth companies selling CPI debt as they can sell it at a better price than RPI debt.”

DMO dependent

The Government has created a massive demand without creating the supply to meet that demand. This mismatch has made it very attractive for issuers to release CPI-linkers – not least for the Government given its colossal borrowing needs.

Says Page: “As the Government has changed the liability profile to CPI it needs to release CPI-linked gilts into the market. There is a call for the Government to be joined up and issue investment solutions to CPI.”

CPI-linked gilt issuance would also create the necessary conditions for an efficient swaps market. Says Leahy: “What needs to happen for the CPI swap market to develop is for a CPI bond market to develop. You always have to look at the underlying instruments that back a derivatives market – just as the RPI swap market has government index-linked bonds.”

The DWP consultation on the impact of a shift to CPI for private sector schemes will close on 2 March. The Government will then consider the responses before issuing its own response later in the year. Only after this does the Debt Management Office envisage conducting its own consultation into the extent of demand for CPI-linked bonds – before eventually releasing products. While CPI-linkers would ultimately solve the problem, it will be a long time before an efficient, liquid market would form.

Best strategy now?

Schemes need to carefully consider the extent to which it is desirable to hedge any form of inflation. Once this decision has been made, the best strategy will almost certainly be to hedge this portion with RPI linkers and make an adjustment for the difference. Says Leahy: “Pension schemes should focus on RPI because they can execute in size, quickly and efficiently right now and get risk off the table.”

As the total liability is decreased, CPI-linked liabilities need to be covered with less RPI-linked securities; Clissold suggests 5% less. Without such an adjustment the scheme will end up with too much protection and could have more efficiently released the excess money to invest in return-seeking assets.

In reality there is not much that schemes can do, at least for the moment. Says Butcher: “Trustees cannot unwind investments until there is an alternative. All they can do is be prepared for when there is something available. Quantify the extent of the switch to CPI and the volume of assets that they would want in CPI-linked assets so they are ready to press the button.”

The extent of desired hedging will ultimately depend on the funding level of the scheme – few will be in a position to index-match entirely at the expense of investing in return generating assets.

The most important segment of liabilities to accurately match is pensions in payment. Assets loosely reserved for deferred or active members are more likely to have time to recover from cyclical dips so would more efficiently be invested in assets with higher expected returns. The DWP statistics suggest that pensions in payment are very likely to remain RPI-indexed. Says Leahy: “Most funds start by hedging a percentage of their liabilities. A logical place to start is pension increases – and 80% of schemes will find that their pension increases are still linked to RPI.”