IAN (Insert No.)Inflation Hedging

IAN (Insert No.)Inflation Hedging

Information and Assistance Notes (IANs) are intended to provide helpful material on particular matters in an accessible form for all members including those who may not have any specialised knowledge in the relevant area. It is not mandatory for members to have regard to an IAN.

MEMBERS ARE REMINDED TO CONSIDER THE PROFESSIONAL CONDUCT STANDARDS (PCS) WHEN ADDRESSING ISSUES WHICH MAY ARISE

Owner Finance and Investment Practice Executive Committee

PurposeThis IANis to help actuaries who may need to consider the investment strategy for liabilities that have inflation exposure in the course of their work, but who have no specialised knowledge of this area.Please refer also to paragraph 3.2 of the PCS.

Target Audience All actuaries

Date of Issue

Latest date by which it will be reviewed 2012

1Background

1.1Pension funds and insurance companies are often exposed to liabilities with exposure to future inflation

1.2The Finance and Investment Practice Executive Committee has issued this IAN to highlight some of the issues around hedging inflation exposure in liabilities and the different approaches by which they can be managed.

2Should pension funds and insurance companies hedge inflation risk?

Factors that should be considered when deciding whether to hedge inflation risk:

How sensitive is the overall solvency position to the inflation exposure?
The trade off between accurate hedging of inflation (which may be complex and costly) against a simpler approach, given the uncertainties in the liabilities (e.g uncertain longevity experience if longevity riskit is not hedged, or if there are uncertainties in the liabilities because of member options such as lump sum commutation or early retirements).
Regulatory capital impact of leaving inflation risk unhedged (for insurance companies)?
Impact of EU “close matching” requirement on insurers for index-linked liabilities, which includes liabilities explicitly indexed to inflation [Paul Fulcher would you like to add anything to this?]
Potential correlation with other risk factors (e.g. which is more important to the fund, the inflation exposure or the real rate exposure?).
Relative valuation – is the cost of hedging inflation cheap or expensive, and is it attractive to lock into an inflation hedge at current market levels.
Are instruments available to accurately hedge the inflation exposure or will there be basisbe basis risk?
Transaction costs of hedging e.g. dealing spreads.
Liquidity of hedge and ability to close out positions.
Are there other inflation exposures that may compensate (e.g. the sponsor of a pension fund may have revenues with a linkage to inflation that may be offsetting – if sponsor covenant is a concern, then a possibility might be to find a bank to swap inflation exposure from the sponsor to the fund).
Any views on the direction of inflation or volatility in future inflation relative to market expectations.

3What type of inflation should be hedged?

3.1In the UK, most pension liabilities are linked to RPI inflation (although the government inflation target is based on CPI). The most liquid traded inflation-linked bonds and swaps are also linked to RPI, because that is the inflation measure used for the index-linked gilt market.

3.2Liabilities linked to LPI (limited price inflation), i.e. RPI inflation with caps and floors, are relatively common. The more common types of LPI linkage are outlined below, although a wide range of different linkages may beare encountered occasionally:

LPI(0,5) year on year. This linkage applies to benefits in payment from occupational pension schemes which are subject to the statutory increases for post 1997 service. It is the most liquid type of LPI linkage in the inflation swaps market.
LPI(0,5) cumulative. This linkage applies for benefits in excess of GMP in deferment for occupational pension schemes. It is difficult to hedge accurately because the exact nature of the inflation linkage is dependent on the date an individual scheme member becomes deferred, and the anticipated retirement date. More commonly RPI is used as a proxy, particularly where a significant period of deferment has already elapsed for a large proportion of the deferred membership (as the realised element of the cumulative LPI is likely to have fallen comfortably inside the cap and the floor).
LPI(0,3) year on year. This linkage applies in payment to post 88 GMP liabilities accrued between 1988 and 1997 for contracted out occupational pension schemes.
LPI(0, infinity). This linkage applies (as a year on year increase) to most occupational pensions that are described as linked to RPI if they are treated accurately, as few pension schemes allow for a reduction in pension if RPI decreases from year to year. For some insured pensions contracts, a cumulative floor applies.
LPI(3,5) year on year. This linkage is relatively common, as historically a number of occupational pension schemes had a 3% floor on pension increases, and this may be combined with the statutory 5% cap applied for post 1997 service.
LPI(3, infinity) year on year. This linkage is occasionally seen, where a 3% floor has applied historically, and no cap is applied.
LPI(0,2.5). This linkage is used for PPF benefits in payment for post 1997 service (so is quite relevant for occupational pension schemes in the PPF Assessment Period). It can also be applied by occupational pension schemes for benefits in payment for post 2004 service, although this is unlikely to represent a significant proportion of defined benefit liabilities, as not all schemes have opted in to this, and many schemes have closed final salary accrual to new entrants, and in some cases to future accrual.

3.3In other markets the inflation linkage in the liabilities may not correspond to the hedging instruments available. E.g. in Ireland, benefits are linked to Irish CPI but the only liquid inflation linked instruments are linked to the Euro HICPx inflation measure. Similarly,

3.3A few some UK pension schemes have some liabilities liked to National Average Earnings (NAE), but there are no investible securities

3.4Investment banks may . A few investment banks might be willing to quote for NAE linked swaps linked to non-standard indices in small size, however the terms offered would reflect the fact that they cannot perfectly hedge the basis risk between NAE and RPIthe swap and available market instruments and would need to carry this risk on their balance sheet.

4What hedging instruments might be used?

The main hedging instruments for UK inflation are listed below.

(a) Index-linked gilts. These come in two formats the old format with an 8 month lag, and the new format (gilts issued since 2005) with daily inflation accrual and a 3 month lag.

(b) Inflation swaps. Market standard format is zero coupon swaps with a 2 month lag.

(d) LPI swaps – inflation swaps that incorporate a cap and/or floor (effectively a combination of an RPI swap with one or more options).

(e)Corporate index-linked bonds. This market is much smaller than the index-linked gilt market, issues are generally small, and liquidity is generally poor as most bonds are held by “buy and hold” investors. An exception is the government guaranteed index-linked bonds issued by Network Rail, which have better liquidity.

(f)Swaptions on inflation. These are attractive in theory however there is no real liquidity in the market because of there is no real supply from investors willing to write inflation swaptions (unlike interest rate swaptions).

(g)Total return swaps on index-linked bonds

(g)(h)Other proxies for inflation. Index-linked bonds and swaps based on inflation measures in other markets in the US and Europe may offer a partial hedge for global inflation risk, but are not such a good hedge for UK inflation exposure linked to RPI because the supply and demand factors are so different.

5Hedging LPI risk

5.1Cumulative LPI risk in deferment is not usually hedged accurately because of the detailed data requirements, the large number of swaps linked to different inflation start and end dates that would be required.

5.2For pension funds and insurance funds with liabilities linked to year on year LPI increases in payment, there is a choice between hedging accurately using LPI swaps, and delta hedging the inflation exposure using RPI linked instruments. The main factors that need to be considered in this decision are:

Materiality of the LPI exposure in the context of the overall liabilities.
Relative valuation of LPI swaps and RPI swaps (this can be expressed in terms of the implied volatility of the caps and floors).
Dealing spreads transacting LPI swaps.
The requirement to monitor and rebalance an RPI delta hedge, and the likely rebalancing costs. Does the pension fund or insurance company have arrangements in place to manage this effectively?
Any views on the direction of inflation or volatility in future inflation relative to market expectations.

6Approaches to hedging inflation

Enter into a hedging arrangement directly with an investment bank
Need to have sufficient in-house knowledge and expertise to assess effectiveness of hedge and pricing
Employ an investment manager with a liability benchmark that incorporates inflation exposure
Investment via pooled funds
Investment via a dedicated pooled fund wrapper
Segregated account (active or passively managed, physical assets and/or swap overlay)
Employ a fiduciary manager (may be a consultant or a fund manager that is benchmarked againstliability risk at fund level and may undertake hedging directly with banks using in-house expertise our out-source to an investment manager)

7Issues that need to be considered when hedging inflation

Basis risk (e.g. where the inflation linkage in the hedge is different to the inflation linkage in the liabilities, or hedging using inflation swaps vs an index-linked gilt benchmark and vice versa).
Hedging on a funded or unfunded basis. If the hedge is on an unfunded basis, either derivatives need to be used or bonds will need to be purchased on an unfunded basis (e.g. making use of a repo agreement).
Managing counterparty risk if inflation swaps are used, in particular collateralisation arrangements. Further information on issues to be considered when hedging inflation using derivatives can be obtained from the Derivatives IAN listed under section 8. Further Reading below.
Pricing and valuation.
Reporting and monitoring the effectiveness of the hedge.
Periodic rebalancing of the hedge.

8Further Reading

Derivatives IAN [has this actually been released yet?]

Modelling inflation-linked benefits

Open Forum: Modelling and matching inflation-linked benefits. 4 November 2008 Andrew Smith

4 Nov 2008

Inflation derivatives: trading persepctives in the UK market

Open Forum: Modelling and matching inflation-linked benefits. 4 November 2008 Dariush Mirfendereski

4 Nov 2008

Modelling and matching inflation-linked benefits

Open Forum: Modelling and matching inflation-linked benefits. 4 November 2008 Alvar Chambers

4 Nov 2008

Controlling the growth of your hedge. Draft Report of a Working Party on Dynamic Investment Strategies

Finance, Investment and Risk Management Conference 2008 Matthew Barnes; Alvar Chambers; Anthony Earnshaw; Stuart Jarvis; Richard McMahon; Peter Ridges

Liability driven benchmarkes for UK defined benefit pension schemes

Finance and Investment Conference 2005 A J Chambers; A E Barnes; M Barnes: L J Beukes: D E Dyer; P Fulcher; M H D Kemp; A M Lawrence; C D Tatham; N M Winter

Actuaries may also need to refer to relevant legislation, accounting standards, regulatory rules and guidance.