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Should Pension Schemes Fear Deflation?

EXECUTIVE SUMMARY

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In May 2015 the UK reported its first year-on-year fall in the Consumer Price Index since the official CPI series began in 1996, with a -0.1% reading[1]. Given pension schemes pay benefits that generally cannot fall from one year to the next, but often hedge with assets that can, we feel it’s relevant to ask the question: should pension schemes fear deflation?

In practice a deflationary period will impact other important market variables, such as equities, interest rates and credit. In this note we deal with the direct inflation consequences only.

There are two distinct ways deflation could harm a pension scheme:

  1. On a valuation basis: the rate used to project future benefit increases contains a floor, but the rate used to project cashflows on assets does not.
  2. On a cashflow basis: the cashflows produced by assets fall from one year to the next, whereas the benefit outgoing does not, creating an unexpected shortfall.

There are three main ways these risks can be handled:

  1. Reserving – the actuary accounts for RPI-floored liabilities at a higher level than RPI, creating a “reserve” in the liability valuation against deflation – although a sustained period of deflation (say a number of years at -2% or lower) could burn through this reserve.
  2. Hedging with Floors – the scheme can buy hedging assets which embed the same inflation floor characteristics as the liabilities (known as LPI swaps) – however, these are illiquid, involve high transaction costs and generally price at levels which have not been justified by historic inflation.
  3. Dynamic Hedging –  the LDI benchmark (that is, the underlying inflation and fixed cashflows that drive the hedging) can be modified as inflation falls in an appropriate way – as inflation falls further and further, the balance between fixed-rate paying asset and inflation-linked assets shifts toward fixed rate assets only.

We advise our clients to put in place dynamic LDI benchmarks, with a framework for regularly refreshing to take market conditions into account (they should be refreshed periodically to allow for demographic changes, but this is on a different timescale). Refreshing too frequently would be over-engineering, but a benchmark left in place for, say, 3 years without updating is liable to become quite stale. We first made this point in a 2013 blog post here.

In practice, this means if we are headed into a sustained period of deflation, the near-term inflation hedging (out to 10 years say) would be steadily unwound as inflation expectations over that horizon declined – see figure 1. The effect might be different at longer horizons.

CONCLUSION

We started by posing the question: Should Pension Schemes Fear Deflation?

The current level of deflation (-0.1% year-on-year CPI as of May 2015) should not by itself be of significant concern to most pension schemes for reasons covered in this report. A deeper and more sustained period of deflation – such as multiple years of realised RPI at -2% or below, accompanied by some translation of this in to future market expectations – could pose a risk to pension schemes. This conclusion is supported by other independent analysis by the RBS Pensions Solutions team[2].

However a dynamic LDI benchmark can mitigate much of this risk by changing the hedge in response to market conditions – pension schemes need not fear deflation.

Deflation is likely to be accompanied by other moves in financial markets, in this note we have considered the direct inflationary effects only. The precise effect on a given scheme is likely to be governed by a number of factors.

Figure 1: Illustrative Change in Liability Benchmark following Negative Inflation Shock

 

CONTEXT – UK PENSION SCHEMES AND INFLATION

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UK defined benefit pension schemes tend to have liabilities linked to inflation, due to the contractual revaluation of benefit payments for active and deferred members each year, and the annual increases granted on pensions in payment.

Historically, this risk exposure to (rising) inflation, and inflation expectations, was one of the largest risks facing pension schemes, which has over time led pension funds more and more to consider investing in assets linked to inflation in order to best hedge this risk.  The increased adoption of LDI strategies has seen many pension schemes successfully address this and substantially reduce the risk being run in their scheme.

However, when a pension schemes starts to build a hedge for its liabilities it quickly discovers a subtle but important feature of its liabilities – while inflation itself can (and has) been negative from one year to the next, in a lot of cases the pension benefits that are paid out cannot decrease from one year to the next.

In the language of the capital markets, the benefits contain inflation floors at 0%. Most also contain caps at 3% or 5% – we first highlighted this issue in a 2013 blog post here.

Figure 2 shows the historic behaviour of inflation-linked benefits with various caps and floors. Over the long-term, these can clearly have a material impact on the outcome (see figure 1).

Figure 2: Long-term compound value of various benefit types (log scale)

 

Figure 3: Selected historical annual growth rates of RPI and RPI floored at 0% p.a.

Figure 3: Selected historical annual growth rates of RPI and RPI floored at 0% p.a.

WHAT’S THE PROBLEM?

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When a pension scheme’s inflation hedge ratio becomes large, say greater than 50%, the subtleties of the inflation exposure in the liabilities can start to matter.

For the first time in decades we have experienced slight deflation in the UK (-0.1% year-on-year change in the CPI index as of May 2015). RPI (for various technical reasons) tends to run somewhat above CPI and the corresponding year-on-year changes have been above zero. The overall message is that a sustained deflationary period, while still unlikely, is becoming a possibility (although market expectations taken from longer dated inflation linked-bonds are, at the time of writing, for the deflationary period to be brief).

For pension schemes with substantial RPI-hedges in place sustained deflation would mean that the cashflows produced by their hedging assets are falling, whereas their liabilities paid out to members must be maintained at the same level.

There are two perspectives on the way this could directly affect pension schemes (leaving aside indirect consequences):

  1. On a valuation basis: the rate used to project future benefit increases contains a floor, but the rate used to project cashflows on assets does not.
  2. On a cashflow basis: the cashflows produced by assets fall from one year to the next, whereas the benefit outgoing does not, creating an unexpected shortfall.

 

In practice the period of deflation may be rather short – if the period of deflation is a few months or even a year with CPI slightly below zero (as currently forecast by markets) this would not make a huge difference to schemes, especially as most schemes base increases on RPI (which is currently running around 1% above CPI). Analysis by the pensions solutions team at RBS[3] suggests that sustained RPI deflation below -2% would be required to leave schemes materially worse off from a cashflow perspective. It should be noted that losses are still evident at milder RPI deflation levels, for example, if RPI is between -1% and -2%, the scheme experiences losses of -1.8%.

Figure 4: Scenario analysis showing cashflow shortfall for hedging a floored payment with RPI and fixed payments

Figure 4: Scenario analysis showing cashflow shortfall for hedging a floored payment with RPI and fixed payments

Source: RBS Pensions Solutions Team

 

What would clearly be material to schemes, for example, would be a repeat of the sustained 1920’s style deflation highlighted in figure 3. Here RPI returned 5% per year less than an RPI linked benefit floored at zero, for a decade (falling in value by a cumulative 25% over the decade as opposed to the floored benefit which grew by 20% over the decade, creating a large gap).

Can these risks be mitigated?

This risk can be mitigated to some degree. There are really three approaches (all of which can be used together):

  1. Reserving – the actuary can project RPI-floored liabilities at a higher rate than RPI, creating a “reserve” in the liability valuation against deflation – although a sustained period of deflation (say a number of years at -2% or lower) could burn through this reserve. The size of this reserve depends on the actuary’s assumption and in practice can vary quite widely between schemes.
  2. Hedging with Floors – the scheme can buy hedging assets which embed the same inflation floor characteristics as the liabilities (known as LPI swaps) – however, these are illiquid, involve high transaction costs and have generally priced at levels which have not been justified by historic inflation.
  3. Dynamic Hedging – the LDI benchmark (that is, the underlying inflation and fixed cashflows that drive the hedging) can be modified as inflation falls in an appropriate way such that the balance between fixed rate-paying assets and RPI-linked assets tips in favour of the former as inflation falls.

 

In practice, schemes can employ a combination of these or indeed all 3 together. Approach (1) is relatively widely used already – it provides a useful first layer of protection, but only up to a point. Approach (2) involves assets that trade in relatively small size and at quite high transaction costs, so is not straightforward to implement or may not be possible at all for larger schemes. Approach (3) we believe is something that all schemes can adopt to help provide an additional layer of protection against changes in inflation. We discuss the dynamic hedging approach in more detail below.

DYNAMIC HEDGING – FOUR SIMPLE QUESTIONS

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Why? What? How? When?

Why?

Having a floor to benefit increases (at 0% p.a.) means that the scheme, as well as being exposed to changes in inflation, is also short an option on inflation at 0%. This creates a subtlety to the scheme’s inflation sensitivity – as the properties of this option will change as the level of inflation changes.

By refreshing the LDI benchmark to take market conditions into account, we can properly reflect the changing effect this option will have on the overall sensitivity to inflation. In practice, this will mean dynamically reducing the exposure to RPI hedging assets as inflation (and inflation expectations) fall.

What?

To do this we need a model that can take into account the scheme’s benefit structure, the current level of inflation, and generate the appropriate liability-matching portfolio. In technical terms we need an option-pricing model that can generate the scheme’s inflation delta.

Many such models exist[4] (see appendix figure A1), the output from one such model[5] is illustrated overleaf for several common benefit tranches. The effect is most pronounced for near-term hedging, for example 5 years which is illustrated in figure 5. Other tenors are shown in figures A2 and A3 in the appendix.

From figure 5, it is clear that while decreases in the inflation hedging can be substantial (from 90% to 50%, say), it does take quite large falls in inflation expectations to drive this (of the order of 2% from where we are now). This should give comfort that a dynamic approach to inflation hedging will not involve excessively frequent trading in the hedging assets. Additional analysis by the pensions team at RBS[6] supports our suggestion that this effect becomes most noticeable for falls in inflation expectation greater than 2%.

For shorter maturities, such as 5 years the inflation hedge for the most common LPI[0,5] liability is progressively reduced as inflation falls as shown below. Interestingly, for longer maturities (and also for the less common LPI[0,3] tranche) the inflation hedge initially increases as inflation falls (due to the changing effect of the cap). This highlights the need for a detailed ALM exercise to examine, at a granular level, the liabilities of the scheme and find the most appropriate hedge.

Figure 5: Reduction in inflation hedge for common benefit types as inflation falls (5 year maturity)

How?

We suggest the market-level refresh should be carried out by the asset manager, based on liability data provided by the actuary (typically the actuarial data will not change much between valuations). Given the importance to a scheme of getting the liability benchmark right, we suggest it is verified by the consultant. In practice there may well be some difference explained by methodology and choice of models between consultant and asset manager. The consultant should work with pragmatic tolerance limits around the calculation.

When?

We suggest a market-level refresh every 3-6 months, or possibly in response to large moves in expected inflation.

Three reasons why we believe this is the best approach:

  1. More dynamic: at higher hedge levels these assumptions really matter and can change significantly over a few months, let alone a year. A benchmark will become very “stale” indeed if left for 3 years.
  2. Greater protection against deflation: A hedged pension scheme’s main defence against a serious period of deflation is a dynamic approach to inflation hedging that gradually takes off the hedge as implied inflation decreases toward zero. The devil is in the detail with these calculations, so a detailed approach is required.
  3. More robust: the LDI benchmark is an asset management benchmark and as such we really see it as a fund management role to calculate this. Fund managers are better set up in terms of systems and process to do this robustly and with less room for miscommunication. In addition a secondary check from a consultant increases the security of the process.

 

CONCLUSION

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We started by posing the question: Should Pension Schemes Fear Deflation?

The current level of deflation (-0.1% year-on-year CPI, as of May 2015) should not by itself be of significant concern to most pension schemes for reasons covered in this report. A deeper and more sustained period of deflation – such as multiple years of realised RPI at -2% or below, accompanied by some translation of this in to future market expectations – could pose a risk to pension schemes. This conclusion is supported by other independent analysis by the RBS Pensions team.

However, a dynamic LDI benchmark can mitigate much of this risk by changing the hedge in response to market conditions – pension schemes need not fear deflation.

Deflation is likely to be accompanied by other moves in financial markets, in this note we have considered the direct inflationary effects only. The precise effect on a given scheme is likely to be governed by a number of factors.

APPENDIX

 

Figure A1: Historic changes in scheme benefit inflation sensitivity (various models)

 

Figure A2: Reduction in RPI hedge required as inflation falls ( SABR model, 20y tenor)

 

Figure A3: Reduction in RPI hedge required as inflation falls (SABR model, 10y tenor)

[1] Source: ONS http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/april-2015/stb—consumer-price-indices—april-2015.html

[2] Analysis available on request from RBS Pensions Solutions team

[3] We are grateful to Robin Thompson and Simon Freedman of RBS for permission to reproduce the results of the analysis, full analysis available on request from RBS

[4] We highlighted the difference in models used in the market in a 2012 blog post, http://blog.redington.co.uk/Articles/Dan-Mikulskis/September-2012/PV01-AND-IE01-MODELS-ON-MODELS.aspx

[5] The model used is the SABR model, modified for year-on-year inflation options

[6] We are grateful to Robin Thompson and Simon Freedman of RBS for permission to reproduce the results of the analysis, full analysis available on request from RBS

 

 

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