Investment Implications of RPI to CPI

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Investment Implications of RPI to CPI

  1. 1. © 2010 The Actuarial Profession  www.actuaries.org.ukRobert Gardner, RedingtonJay Shah, Pension CorporationInvestment Implicationsof RPI to CPI4 October 2011
  2. 2. The Inflation basket1© 2010 The Actuarial Profession  www.actuaries.org.ukRPI:+ Financial Services
  3. 3. What has happened2© 2010 The Actuarial Profession  www.actuaries.org.ukLegislative changesProposed switch instatutory indexation:RPI to CPIImplementation8 December 2010Consultationlaunched8 July 2010 6 April 2011
  4. 4. RPI vs. CPI3© 2010 The Actuarial Profession  www.actuaries.org.ukWhy it’s happened• CPI is BoE’sbenchmark for thewhole economy• Only 7% ofpensioners havean outstandingmortgage123Standard Deviation:•RPI 1.54•CPI 1.02Source: ONS• (Reduce public pension liabilities...)-2-10123456PercentageRPI (y/y) CPI (y/y)
  5. 5. How it’s happened4© 2010 The Actuarial Profession  www.actuaries.org.ukPublic 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
  6. 6. Risk managementUK inflation – the long runLong run difference• Aggregate price changes• Mathematical formula• 2010 formula effect topersist• Permanent 0.3% differenceimplied• Long-run estimate of 1.2%“wedge”.5© 2010 The Actuarial Profession  www.actuaries.org.ukFormula effectSource: ONS
  7. 7. Risk managementUK inflation - April 2011• CPI jumped from4% to 4.5% in April• Currently remainabove forecasts of4.1%• RPI floats around5.2%...6© 2010 The Actuarial Profession  www.actuaries.org.ukCPI up, RPI downSource: ONS, Redington0123456PercentageRPI (y/y) CPI (y/y)
  8. 8. Risk managementHedging inflation7© 2010 The Actuarial Profession  www.actuaries.org.ukFinding relative valueSource: Bloomberg, Redington-1.50-1.00-0.500.000.501.001.502.0030y Swap Real Yield 20y Gilt Real Yield 30y Swap Spread (Swap Yield - Gilt Yield)
  9. 9. Risk managementHedging CPI Swaps Pricing*8© 2010 The Actuarial Profession  www.actuaries.org.uk• 20 year RPI 3.475% - 3.575%• (Mid – 3.525% and 5bp spread)• 30 Year RPI 3.927% - 3.655%• (Mid – 3.605% and 5bp spread)• Vs• 20 year CPI 2.852% - 3.252%• (Mid – 3.052% and 20bp spread)• 30 Year CPI 2.927% - 3.327%• (Mid – 3.127% and 20bp spread)RPI/CPI spread• 20 year CPI Mid – 3.052% and 20 year RPIMid – 3.525%• = -0.473% with at least 20bps spread.• 30 year CPI Mid – 3.127% and 30 year RPIMid – 3.605%• = -0.478% with at least 20bps spread.Source: RBS
  10. 10. Risk managementHedging inflation9© 2010 The Actuarial Profession  www.actuaries.org.ukHedging CPIPhysical assets• CPI-linked gilts?• Flight PlanConsistent Assets(FPCA)• CPI bond market...?CPI
  11. 11. Risk managementAlternative Sources of CPI10© 2010 The Actuarial Profession  www.actuaries.org.uk-6-4-2024680 5 10 15 20 25 30GBPMillionsYearsInitial investmentAttractive real returnsInflation-linked cashflowsProviding a match for liabilitiesInflowsOutflowsSource: RedingtonFlight Plan Consistent Asset – Example Cashflow Profile
  12. 12. Risk managementAlternative Sources of CPI11© 2010 The Actuarial Profession  www.actuaries.org.ukMost RiskPricing mechanismLeast RiskSectorAvailability Regulatory Demand Economic PriceMost RiskLeast RiskSource: Evolution Securities, Redington
  13. 13. Recap of bulk annuity market growth12© 2010 The Actuarial Profession  www.actuaries.org.ukColumn: Stack01,0002,0003,0004,0005,0006,0007,0008,0009,0002004 2005 2006 2007 2008 2009 2010(£ million)Pension insurancebuyout / buy-inPension insurance buyout CAGR¹: 66%Longevity insuranceMarket growth maintained Transactions examples
  14. 14. 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 delayed13© 2010 The Actuarial Profession  www.actuaries.org.uk
  15. 15. Pension scheme view of CPI vs. RPI14© 2010 The Actuarial Profession  www.actuaries.org.ukRPI vs CPI Index: January 1988=10075100125150175200225198801198901199001199101199201199301199401199501199601199701199801199901200001200101200201200301200401200501200601200701200801200901201001RPI rebasedCPI rebased
  16. 16. Expectations of RPI to CPI gap15Party / Source RPI-CPI assumptionThe Office for Budget Responsibility, Economic andFiscal outlook of March 20111.2%FTSE350 Pension Fund accounting disclosures,Hymans Robertson’s 2011 survey0.7% to 2.8%Mercer briefing July 2011 0.5% to 0.8%Investment Bank instruments 0.1% to 0.2%Our survey See later slides
  17. 17. Insurer view of CPI vs. RPI16© 2010 The Actuarial Profession  www.actuaries.org.ukRPI 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%198909199009199109199209199309199409199509199609199709199809199909200009200109200209200309200409200509200609200709200809200909YoY % increase RPIYoY % increase CPI
  18. 18. RPI v CPI: Historic differences• The average annual RPI-CPI gap from May 1997 to July 2011was 0.88%• Annualised standard deviation of monthly observed RPI-CPI basis was1.27%• RPI was above CPI for 85% of the period– Main period of negative RPI-CPI due to rapid mortgage cost inflationreduction over 200817
  19. 19. RPI v CPI density function18Histogram of RPI-CPI since May 1997 and approximated density functionAbnormal – e.g. falling interest ratesmean of – 2.9% (CPI higher)Normal : mean of 1.1%(RPI higher)
  20. 20. RPI vs. CPI – stochastic simulation – nounderpin19© 2010 The Actuarial Profession  www.actuaries.org.ukSource: Barrie and Hibbert
  21. 21. RPI vs. CPI – stochastic simulation – withunderpin!20© 2010 The Actuarial Profession  www.actuaries.org.ukSource: Barrie and Hibbert
  22. 22. CPI, RPI and base rates21© 2010 The Actuarial Profession  www.actuaries.org.uk
  23. 23. Hedge with RPI – implications for insurers• 1 in 200 year test – capital requirements– statistical variation– changes in the basket of goods– changes in calculation methodology– political influence• Shock effects if CPI market develops differently• Impact of caps and floors:– Volatility of CPI is lower than RPI– So floor and cap both less likely to bite? Net impact?22© 2010 The Actuarial Profession  www.actuaries.org.uk
  24. 24. Hedge with CPI23© 2010 The Actuarial Profession  www.actuaries.org.uk• Investment Bank A : CPI vs RPI = 0.1%• Investment Bank B : CPI v RPI = 0.2%• Capacity available : SmallInstrument Approx market sizeIndexed RPI gilts £270 bnIndexed RPI bonds £30 bnRPI Inflation swaps £100 bnCPI linked Virtually nil
  25. 25. Insurer solutions• Insure on CPI but no discount to RPI– Benefits indexed to CPI– Expected CPI under-run– Offset by cost of risk capital• Option 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?24© 2010 The Actuarial Profession  www.actuaries.org.uk
  26. 26. But general market movements more significant25© 2010 The Actuarial Profession  www.actuaries.org.uk• Affordability chart reflects approximate asset/liability mix ofthe Scheme (c70% equities and 80% non-pensioners)• Chart assumes scheme is fully funded initially – for anunderfunded scheme the volatility in the deficit will be muchlarger
  27. 27. Our survey says...© 2010 The Actuarial Profession  www.actuaries.org.uk
  28. 28. Survey ResultsAudience1. What proportion of inflation-linked liabilities are matchedwith inflation hedging assets such as index-linked gilts,inflation swaps or buy-in insurance policies:27© 2010 The Actuarial Profession  www.actuaries.org.uk16 participants0%10%20%30%40%50%60%70%0% - 25% 25% - 50% 50% - 75% 75% - 100%Proportion of matching assets
  29. 29. Survey ResultsNationwide1. What proportion of inflation-linked liabilities are matchedwith inflation hedging assets such as index-linked gilts,inflation swaps or buy-in insurance policies:28© 2010 The Actuarial Profession  www.actuaries.org.uk88 Actuaries, 19 Trustees0%10%20%30%40%50%60%70%0% - 25% 25% - 50% 50% - 75% 75% - 100%Proportion of matching assetsActuaries Trustees
  30. 30. Survey ResultsAudience2. Broadly what proportion specify statutory minimumrevaluation/indexation, i.e. they could automatically moveto CPI:29© 2010 The Actuarial Profession  www.actuaries.org.uk16 participants0%10%20%30%40%50%60%70%80%<25% 25% - 50% 50%-75% >75%"Statutory minimum" specifiedRevaluation in deferment Benefit indexation in payment
  31. 31. Survey ResultsAudience3. For those that could automatically move to CPI, will thoseSchemes move to CPI (rather than retain RPI):30© 2010 The Actuarial Profession  www.actuaries.org.uk16 participants0%10%20%30%40%50%60%70%80%90%100%Yes NoProportion of schemesYes No
  32. 32. Survey ResultsAudience4. In your view is it fair that schemes that can move to CPIshould move to CPI?31© 2010 The Actuarial Profession  www.actuaries.org.uk15 participantsYes67%No33%
  33. 33. Survey ResultsNationwide4. In your view is it fair that schemes that can move to CPIshould move to CPI?32© 2010 The Actuarial Profession  www.actuaries.org.uk70 Actuaries, 19 Trustees0%10%20%30%40%50%60%70%80%Yes NoActuariesTrustees
  34. 34. Survey ResultsAudience5. What is your long term expectation for CPI inflationrelative to RPI inflation:33© 2010 The Actuarial Profession  www.actuaries.org.uk16 participants0% 10% 20% 30% 40% 50% 60% 70% 80%Same as RPIc.0.5% p.a. less than RPIc.0.5% to 1% p.a. less than RPI1% to 2% less than RPI
  35. 35. Survey ResultsNationwide5. What is your long term expectation for CPI inflationrelative to RPI inflation:34© 2010 The Actuarial Profession  www.actuaries.org.uk89 Actuaries, 19 Trustees0% 10% 20% 30% 40% 50% 60% 70% 80%Same as RPIc.0.5% p.a. less than RPIc.0.5% to 1% p.a. less than RPI1% to 2% less than RPIActuaries Trustees
  36. 36. Survey ResultsAudience6. Of possible de-risking options, which of the following doyou think your schemes consider seriously over the next3 years:35© 2010 The Actuarial Profession  www.actuaries.org.uk0%10%20%30%40%50%60%70%80%90%100%Buy-in or buy-out Longevity swap LiabilityManagementexerciseNone OtherUnlikely Likely Almost certainly
  37. 37. Survey ResultsNationwide6. Of possible de-risking options, which of the following doyou think your schemes consider seriously over the next3 years:36© 2010 The Actuarial Profession  www.actuaries.org.uk87 Actuaries, 18 Trustees0%10%20%30%40%50%60%Unlikely Likely Almost certainlyLiability Management ExerciseActuariesTrustees
  38. 38. Survey ResultsNationwide6. Of possible de-risking options, which of the following doyou think your schemes consider seriously over the next3 years:37© 2010 The Actuarial Profession  www.actuaries.org.uk86 Actuaries, 13 Trustees0%10%20%30%40%50%60%70%80%90%Unlikely Likely Almost certainlyLongevity SwapActuariesTrustees
  39. 39. Survey ResultsNationwide6. Of possible de-risking options, which of the following doyou think your schemes consider seriously over the next3 years:38© 2010 The Actuarial Profession  www.actuaries.org.uk87 Actuaries, 19 Trustees0%10%20%30%40%50%60%70%Unlikely Likely Almost certainlyBuy-in/Buy-outActuariesTrustees
  40. 40. Survey Results39© 2010 The Actuarial Profession  www.actuaries.org.uk6. Other:“More direct investment in gilts rather than swaps”National responses“Journey planning / flight path / de-risking triggers”“Phased buy-in, via annuity purchase when members retire”“Closing to future accrual (for those few schemes still open)”“Increase in LDI assets”“Winding up”“More bonds”
  41. 41. Survey Results40© 2010 The Actuarial Profession  www.actuaries.org.uk7. What impact has the CPI move had on schemesconsidering de-risking?“Little / None”“Potential reduction in Buy-out cost. Slightly more scope to exchangepension increases. Some offset CPI gains through lower risk investmentstrategy”“Caused delays to some looking at buy-in/out because insurers havebeen unable to provide CPI pricing”“As far as I am aware [public sector schemes] are not looking to derisk,other than via wholesale benefit changes following Huttons report”
  42. 42. Questions or comments?41© 2010 The Actuarial Profession  www.actuaries.org.ukJay Shah• Co-Head of Business Origination• Pension Corporation• shahj@pensioncorporation.com• Tel: + 44 20 7105 2111Robert Gardner• Co-Chief Executive• Redington• robert.gardner@redington.co.uk• Tel: + 44 20 7250 3416 In addition... http://twitter.com/robertjgardner http://uk.linkedin.com/in/robertjgardner

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