RPI reform drives up inflation hedging cost

The government’s response to the RPI reform consultation, published in November, confirmed the long-expected change to RPI that will see it aligned with the consumer price index including housing costs by 2030.

The change will not include compensation for inflation-linked bond holders for the subsequent fall in the value of those bonds. The CPIH typically runs at 1 percentage point a year below the RPI rate.

Yet David Jamieson, market strategist at Insight, noted that although the post-reform lowering of RPI might have been expected to cut the RPI hedging cost over 30 years, the cost actually rose from 3 per cent before the consultation response was announced to 3.15 per cent afterwards.

We may see some increased index-linked gilt trading activity going forward, where liability benchmarks are revised as actuaries change their assumption about the RPI-CPI wedge post-2030

Kate Mijakowska, Redington

He told Pensions Expert that the move has had a knock-on effect on CPI-linked liabilities, with CPI 30-year rates also rising. CPI is at present priced at 2.9 per cent, comfortably above the Bank of England’s two per cent target.

Mr Jamieson attributed this change to two factors, the first being pent-up demand. He said uncertainty during the consultation period saw demand for inflation hedging dropping dramatically, entering “a hiatus period” where net purchases were “very close to zero”.

This was “vastly different” from the average of 30-year-plus maturity inflation-linked bonds with a per-basis-point interest rate sensitivity of £20 million bought per year by Insight for the past five years, he noted.

With the closure of the consultation re-establishing certainty, that demand is now returning. It is exacerbated by the rising cost of CPI 30-year rates, Mr Jamieson continued. 

“The fact that the CPI 30-year rate went up by 35 basis points means their [pension schemes’] liability is going to increase, and if the current liabilities increase that means we’ve got more hedging to do. So as well as pent-up demand, you’ve actually got new demand that wasn’t there before.”

However, prospective hedgers will be hampered by the unavailability of bonds issued by the Debt Management Office, reflecting a conscious decision by the DMO to cut the number of these in the total balance sheet, he cautioned.

While in previous years, around 20 per cent of the bonds issued were index-linked; that number has now fallen to 6 per cent, though distorted by Covid-19, he noted.

And although the issuance is not expected to remain this low — rising to potentially 10 or 15 per cent — the likelihood is that the number of 30-year inflation-linked bonds in particular will be far outstripped by demand, making it difficult for clients to make up time if they cut back on inflation hedging during the consultation, Mr Jamieson added.

RPI reform impact ‘hard to isolate’

LCP partner Alex Waite concurred that the higher price for inflation “almost certainly reflects buyers moving back into the market after a brief hiatus”, but cautioned that there were several other announcements on the day that the consultation response was published, “so it is hard to isolate just the impact of RPI reform”.

“Importantly, there is a lot of concern about future high inflation and that is something that pension schemes have always been very concerned about, given the statutory requirement to increase pensions in line with inflation,” Mr Waite said.

“There is always a shortage of inflation-linked bonds, and a huge demand from pension schemes (as well as other investors) and so the market can be highly inelastic. There is also a query as to whether the government will want to issue linkers when it is possible that inflation will be the best means by which to decrease the debt pile.”

Kate Mijakowska, director of manager research at Redington, noted that while a trend of clients deliberately under-hedging inflation risk in anticipation of the RPI reform outcome did not exist, “some clients with meaningful CPI linkage in their liabilities sought to opportunistically gain CPI swap exposure where possible”. 

“We may see some increased index-linked gilt trading activity going forward, where liability benchmarks are revised as actuaries change their assumption about the RPI-CPI wedge post-2030,” Ms Mijakowska said.

The inflation risk premium will be particularly important when company accounting figures are set on December 31, Aon partner Lynda Whitney noted, as “a higher inflation risk premium leads to lower disclosed liabilities in company accounts”.

“Since the announcement, there does seem to be a view forming that inflation risk premiums have increased,” she said.

Welcomed clarity for trustees

Nick Chadha, chief operating officer and trustee principal at PAN Trustees, explained that “increased demand pushing up gilt prices — and therefore reducing yields — will compound the effect of increased inflation expectations”.

“This in turn pushes up the value of liabilities which, for those schemes not fully hedged, will put pressure on funding levels.” 

Mr Chadha added, however, that trustees will appreciate there is now certainty about the future of RPI, “and this may unblock hedging planning that has been stalled on some schemes”.

“It is incumbent on trustees to make sure they are working with their actuaries and investment consultants to fully understand the outcome and impact of the consultation and how their schemes may be affected,” he said. 

“This is a highly technical area and not always an intuitive one — hence trustee boards need their investment consultants to be properly on point in articulating the issues to enable robust decisions to be taken.”