Investment Implications of RPI to CPI

© 2010 The Actuarial Profession www.actuaries.org.uk

Robert Gardner, Redington David Collinson, Pension Corporation

Investment Implications

of RPI to CPI

13 March 2012

The Inflation basket

1 © 2010 The Actuarial Profession www.actuaries.org.uk

RPI:

+ Financial Services

RPI vs. CPI


Why it’s happened

• CPI is BoE’s

benchmark for the

whole economy

• Only 7% of

pensioners have an

outstanding

mortgage

•(Reduce public

pension liabilities...)

1

2

3

Standard Deviation:

•RPI 1.58

•CPI 1.15

Source: ONS

-2

-1

0

1

2

3

4

5

6

Jan 2000

Jan 2001

Jan 2002

Jan 2003

Jan 2004

Jan 2005

Jan 2006

Jan 2007

Jan 2008

Jan 2009

Jan 2010

Jan 2011

Jan 2011

Perc

en

tag

e

RPI (y/y) CPI (y/y)

How it’s happened


Public 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

Risk management UK inflation – the long run

Long run difference • Aggregate price changes

• Mathematical formula

• 2010 formula effect to persist

• Permanent 0.3% difference implied

• Long-run estimate of 1.2% “wedge”.


Formula effect

Source: ONS

• Sharp fall in both

RPI and CPI since

September 2011

• RPI at 3.9% in

January vs. 3.6%

for CPI

• Spread at narrowest

since early 2010

Risk management UK inflation - January 2012


CPI and RPI down

Source: ONS, Redington

0

1

2

3

4

5

6

Perc

en

tag

e

RPI (y/y) CPI (y/y)

Risk management Hedging inflation


Finding relative value

Source: Bloomberg, Redington

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

%

30-Year Gilt Real Yield 30-Year Swap Real Yield Swap Spread (Swap Yield - Gilt Yield)

Risk management Hedging CPI Swaps Pricing*


• 20 year RPI 3.475% - 3.575%

• (Mid – 3.525% and 5bp spread)

• 30 Year RPI 3.927% - 3.655%


• Vs

• 20 year CPI 2.852% - 3.252%


• 30 Year CPI 2.927% - 3.327%


RPI/CPI spread

• 20 year CPI Mid – 3.052% and 20 year RPI

Mid – 3.525%

• = -0.473% with at least 20bps spread.

• 30 year CPI Mid – 3.127% and 30 year RPI

Mid – 3.605%

• = -0.478% with at least 20bps spread.

Source: RBS

Risk management Hedging inflation


Hedging CPI

Physical assets

• CPI-linked gilts?

• Flight Plan

Consistent Assets

(FPCA)

• CPI bond market...?

CPI

Risk management Alternative Sources of CPI


-6

-4

-2

0

2

4

6

8

0 5 10 15 20 25 30

GB

P M

illi

on

s

Years

Initial investment

Attractive real returns

Inflation-linked cashflows

Providing a match for liabilities

Inflows

Outflows

Source: Redington

Flight Plan Consistent Asset – Example Cashflow Profile

Risk management Alternative Sources of CPI


Source: Evolution Securities, Redington

Most Risk Least Risk

Inherent

Sector Risk

Pricing

Mechanism

Satellites Generation

Ports

Environmental Renewables Airports

Storage Pipelines

Distribution Masts

Water Transmission

Bridges/Tunnels Rail

Defence Roads Transport

Education Healthcare

Social Housing

11

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

2004 2005 2006 2007 2008 2009 2010 2011

Forecast Q4 2011

Longevit y Swaps

Pension Insurance buy-out

Development of the insurance market for pensions in the UK since 2004

Source: PC analysis, LCP Buyout Report 2010, Hymans Robertson 2010 and H1 2011

Update

1) 2009 figures include £1.9bn RSA longevity transaction completed in July 2009

http://images.thecarconnection.com/lrg/bmw-logo_100167022_l.jpg

http://www.liberty-international.co.uk/

http://www.rsagroup.com/rsa

http://www.itv.com/Channels/ITV1/default.html

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 delayed


Pension scheme view of CPI vs. RPI


Expectations of RPI to CPI gap

14

Party / Source RPI-CPI assumption

The Office for Budget Responsibility, Economic and

Fiscal outlook of March 2011

1.2%

FTSE350 Pension Fund accounting disclosures,

Hymans Robertson’s 2011 survey

0.7% 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

Insurer view of CPI vs. RPI


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 was

1.27%

• RPI was above CPI for 85% of the period

– Main period of negative RPI-CPI due to rapid mortgage cost inflation

reduction over 2008

16

RPI v CPI density function

17

Histogram of RPI-CPI since May 1997 and approximated density function

Abnormal – e.g. falling interest rates

mean of – 2.9% (CPI higher)

Normal : mean of 1.1%

(RPI higher)

RPI vs. CPI – stochastic simulation – no underpin


Source: Barrie and Hibbert

RPI vs. CPI – stochastic simulation – with underpin!


Source: Barrie and Hibbert

CPI, RPI and base rates


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?


Hedge with CPI


• Investment Bank A : CPI vs RPI = 0.1%

• Investment Bank B : CPI v RPI = 0.2%

• Capacity available : Small

Instrument Approx market size

Indexed RPI gilts £270 bn

Indexed RPI bonds £30 bn

RPI Inflation swaps £100 bn

CPI linked Virtually nil

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?


But general market movements more significant


• Chart shows ‘overall affordability’ for a scheme with a blend of deferred and pensioner liabilities, and

invested in a 55% equities / 45% bonds mix. ‘Affordability’ considers the cost of insuring the pension

risk compared to the value of the assets held by the scheme. A higher value in the index means that

insurance is more affordable for pension schemes (insurance costs have fallen and / or asset values

have risen)

• Bulk annuity affordability plunged during the second half of 2011, primarily due to ultra-low Gilt yields,

but equities also dragged down funding positions

50.0

55.0

60.0

65.0

70.0

75.0

80.0

Fundin

g level in

% Affordability

Redington – Pension Corporation Survey 112 Actuaries and Trustees between May and October 2011


• Overwhelming majority of schemes vulnerable to future

inflation increases

• Less than 20% of defined benefit pension schemes surveyed

had at least 50% of their inflation-linked pensions backed with

inflation-linked assets such as index-linked gilts

• General inflation risk a much greater risk to most schemes

than CPI/RPI basis risk

Key Findings / Conclusions

Our survey says...

© 2010 The Actuarial Profession www.actuaries.org.uk

Survey Results

1. What proportion of inflation-linked liabilities are matched

with inflation hedging assets such as index-linked gilts,

inflation swaps or buy-in insurance policies:


Based on responses from 88 Actuaries

and 13 Trustees

0%

10%

20%

30%

40%

50%

60%

70%

0% - 25% 25% - 50% 50% - 75% 75% - 100%

Proportion of matching assets

Actuaries Trustees

Survey Results

2. To Trustees: Does your scheme specify statutory

minimum revaluation / indexation, i.e. could the scheme

automatically move to CPI?


0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Yes No

"Statutory minimum" specified

Revaluation in deferment Benefit indexation in payment

Based on responses from 21 trustees

Survey Results

3. To Trustees: Will your scheme move to CPI (rather than

retain RPI):


Based on responses from 20 trustees

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Yes No

Proportion of schemes

Revaluation in deferment Benefit indexation in payment

Survey Results

4. In your view is it fair that schemes that can move to CPI

should move to CPI?


0%

10%

20%

30%

40%

50%

60%

70%

80%

Yes No

Actuaries

Trustees


and 23 Trustees

Survey Results

5. What is your long term expectation for CPI inflation

relative to RPI inflation:


0% 10% 20% 30% 40% 50% 60% 70% 80%

Same as RPI

c.0.5% p.a. less than RPI

c.0.5% to 1% p.a. less than RPI

1% to 2% less than RPI

Actuaries Trustees


and 23 Trustees

Survey Results

6. Of possible de-risking options, which of the following do

you think your schemes consider seriously over the next

3 years:


0%

10%

20%

30%

40%

50%

60%

Unlikely Likely Almost certainly

a. Liability Management Exercise

Actuaries

Trustees


and 22 Trustees

Survey Results



3 years:


0%

10%

20%

30%

40%

50%

60%

70%

80%

90%


b. Longevity Swap

Actuaries

Trustees


and 21 Trustees

Survey Results



3 years:


0%

10%

20%

30%

40%

50%

60%

70%


c. Buy-in/Buy-out

Actuaries

Trustees


and 23 Trustees

Survey Results


d. 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”



3 years:

Survey Results


7. What impact has the CPI move had on schemes

considering de-risking?

“Little / None”

“Potential reduction in Buy-out cost. Slightly more scope to exchange

pension increases. Some offset CPI gains through lower risk investment

strategy”

“Caused delays to some looking at buy-in/out because insurers have

been 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”

Questions or comments?


David Collinson

• Co-Head of Business Origination

• Pension Corporation

• [email protected]

• Tel: + 44 20 7105 2110

Robert Gardner

• Co-Chief Executive

• Redington

• [email protected]

• Tel: + 44 20 7250 3416

In addition...

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Economy & Finance

Investment Implications of RPI to CPI