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Investment Implications of RPI to CPI

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  • 1. © 2010 The Actuarial Profession  www.actuaries.org.ukRobert Gardner, RedingtonDavid Collinson, Pension CorporationInvestment Implicationsof RPI to CPI13 March 2012
  • 2. The Inflation basket1© 2010 The Actuarial Profession  www.actuaries.org.ukRPI:+ Financial Services
  • 3. RPI vs. CPI2© 2010 The Actuarial Profession  www.actuaries.org.ukWhy it’s happened• CPI is BoE’sbenchmark for thewhole economy• Only 7% ofpensioners have anoutstandingmortgage•(Reduce publicpension liabilities...)123Standard Deviation:•RPI 1.58•CPI 1.15Source: ONS-2-10123456Jan2000Jan2001Jan2002Jan2003Jan2004Jan2005Jan2006Jan2007Jan2008Jan2009Jan2010Jan2011Jan2011PercentageRPI (y/y) CPI (y/y)
  • 4. How it’s happened3© 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
  • 5. 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”.4© 2010 The Actuarial Profession  www.actuaries.org.ukFormula effectSource: ONS
  • 6. • Sharp fall in bothRPI and CPI sinceSeptember 2011• RPI at 3.9% inJanuary vs. 3.6%for CPI• Spread at narrowestsince early 2010Risk managementUK inflation - January 20125© 2010 The Actuarial Profession  www.actuaries.org.ukCPI and RPI downSource: ONS, Redington0123456PercentageRPI (y/y) CPI (y/y)
  • 7. Risk managementHedging inflation6© 2010 The Actuarial Profession  www.actuaries.org.ukFinding relative valueSource: Bloomberg, Redington-1.5-1.0-0.50.00.51.01.52.0%30-Year Gilt Real Yield 30-Year Swap Real Yield Swap Spread (Swap Yield - Gilt Yield)
  • 8. Risk managementHedging CPI Swaps Pricing*7© 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
  • 9. Risk managementHedging inflation8© 2010 The Actuarial Profession  www.actuaries.org.ukHedging CPIPhysical assets• CPI-linked gilts?• Flight PlanConsistent Assets(FPCA)• CPI bond market...?CPI
  • 10. Risk managementAlternative Sources of CPI9© 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
  • 11. Risk managementAlternative Sources of CPI10© 2010 The Actuarial Profession  www.actuaries.org.ukSource: Evolution Securities, RedingtonMost RiskLeast RiskInherentSector RiskPricingMechanismSatellites GenerationPortsEnvironmental Renewables AirportsStorage PipelinesDistribution MastsWater TransmissionBridges/Tunnels RailDefence Roads TransportEducation HealthcareSocial Housing
  • 12. 1101,0002,0003,0004,0005,0006,0007,0008,0009,0002004 2005 2006 2007 2008 2009 2010 2011Forecast Q4 2011Longevit y SwapsPension Insurance buy-outDevelopment of the insurance market forpensions in the UK since 2004Source: PC analysis, LCP Buyout Report 2010, Hymans Robertson 2010 and H1 2011Update1) 2009 figures include £1.9bn RSA longevity transaction completed in July 2009
  • 13. 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 delayed12© 2010 The Actuarial Profession  www.actuaries.org.uk
  • 14. Pension scheme view of CPI vs. RPI13© 2010 The Actuarial Profession  www.actuaries.org.uk
  • 15. Expectations of RPI to CPI gap14Party / 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
  • 16. Insurer view of CPI vs. RPI15© 2010 The Actuarial Profession  www.actuaries.org.uk
  • 17. RPI v CPI: Historic differences• The average annual RPI-CPI gap from May 1997 to July 2011 was 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 200816
  • 18. RPI v CPI density function17Histogram 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)
  • 19. RPI vs. CPI – stochastic simulation – nounderpin18© 2010 The Actuarial Profession  www.actuaries.org.ukSource: Barrie and Hibbert
  • 20. RPI vs. CPI – stochastic simulation – withunderpin!19© 2010 The Actuarial Profession  www.actuaries.org.ukSource: Barrie and Hibbert
  • 21. CPI, RPI and base rates20© 2010 The Actuarial Profession  www.actuaries.org.uk
  • 22. 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?21© 2010 The Actuarial Profession  www.actuaries.org.uk
  • 23. Hedge with CPI22© 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
  • 24. Insurer solutions• Insure on CPI but small 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?23© 2010 The Actuarial Profession  www.actuaries.org.uk
  • 25. But general market movements more significant24© 2010 The Actuarial Profession  www.actuaries.org.uk• Chart shows ‘overall affordability’ for a scheme with a blend of deferred and pensioner liabilities, andinvested in a 55% equities / 45% bonds mix. ‘Affordability’ considers the cost of insuring the pensionrisk compared to the value of the assets held by the scheme. A higher value in the index means thatinsurance is more affordable for pension schemes (insurance costs have fallen and / or asset valueshave risen)• Bulk annuity affordability plunged during the second half of 2011, primarily due to ultra-low Gilt yields,but equities also dragged down funding positions50.055.060.065.070.075.080.0Fundinglevelin%Affordability
  • 26. Redington – Pension Corporation Survey112 Actuaries and Trustees between May and October 201125© 2010 The Actuarial Profession  www.actuaries.org.uk• Overwhelming majority of schemes vulnerable to futureinflation increases• Less than 20% of defined benefit pension schemes surveyedhad at least 50% of their inflation-linked pensions backed withinflation-linked assets such as index-linked gilts• General inflation risk a much greater risk to most schemesthan CPI/RPI basis riskKey Findings / Conclusions
  • 27. Our survey says...© 2010 The Actuarial Profession  www.actuaries.org.uk
  • 28. Survey Results1. 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.ukBased on responses from 88 Actuariesand 13 Trustees0%10%20%30%40%50%60%70%0% - 25% 25% - 50% 50% - 75% 75% - 100%Proportion of matching assetsActuaries Trustees
  • 29. Survey Results2. To Trustees: Does your scheme specify statutoryminimum revaluation / indexation, i.e. could the schemeautomatically move to CPI?28© 2010 The Actuarial Profession  www.actuaries.org.uk0%10%20%30%40%50%60%70%80%90%Yes No"Statutory minimum" specifiedRevaluation in deferment Benefit indexation in paymentBased on responses from 21 trustees
  • 30. Survey Results3. To Trustees: Will your scheme move to CPI (rather thanretain RPI):29© 2010 The Actuarial Profession  www.actuaries.org.ukBased on responses from 20 trustees0%10%20%30%40%50%60%70%80%90%100%Yes NoProportion of schemesRevaluation in deferment Benefit indexation in payment
  • 31. Survey Results4. In your view is it fair that schemes that can move to CPIshould move to CPI?30© 2010 The Actuarial Profession  www.actuaries.org.uk0%10%20%30%40%50%60%70%80%Yes NoActuariesTrusteesBased on responses from 85 Actuariesand 23 Trustees
  • 32. Survey Results5. What is your long term expectation for CPI inflationrelative to RPI inflation:31© 2010 The Actuarial Profession  www.actuaries.org.uk0% 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 TrusteesBased on responses from 89 Actuariesand 23 Trustees
  • 33. Survey Results6. Of possible de-risking options, which of the following doyou think your schemes consider seriously over the next3 years:32© 2010 The Actuarial Profession  www.actuaries.org.uk0%10%20%30%40%50%60%Unlikely Likely Almost certainlya. Liability Management ExerciseActuariesTrusteesBased on responses from 87 Actuariesand 22 Trustees
  • 34. Survey Results6. Of possible de-risking options, which of the following doyou think your schemes consider seriously over the next3 years:33© 2010 The Actuarial Profession  www.actuaries.org.uk0%10%20%30%40%50%60%70%80%90%Unlikely Likely Almost certainlyb. Longevity SwapActuariesTrusteesBased on responses from 86 Actuariesand 21 Trustees
  • 35. Survey Results6. Of possible de-risking options, which of the following doyou think your schemes consider seriously over the next3 years:34© 2010 The Actuarial Profession  www.actuaries.org.uk0%10%20%30%40%50%60%70%Unlikely Likely Almost certainlyc. Buy-in/Buy-outActuariesTrusteesBased on responses from 87 Actuariesand 23 Trustees
  • 36. Survey Results35© 2010 The Actuarial Profession  www.actuaries.org.ukd. Other:“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”6. Of possible de-risking options, which of the following doyou think your schemes consider seriously over the next3 years:
  • 37. Survey Results36© 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”
  • 38. Questions or comments?37© 2010 The Actuarial Profession  www.actuaries.org.ukDavid Collinson• Co-Head of Business Origination• Pension Corporation• collinson@pensioncorporation.com• Tel: + 44 20 7105 2110Robert 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