Investment Implications of RPI to CPI

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

Robert Gardner, Redington Jay Shah, Pension Corporation

Investment Implications

of RPI to CPI

4 October 2011

The Inflation basket

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

RPI:

+ Financial Services

What has happened


Legislative changes

Proposed switch in

statutory indexation:

RPI to CPI

Implementation

8 December 2010

Consultation

launched

8 July 2010 6 April 2011

RPI vs. CPI


Why it’s happened

• CPI is BoE’s

benchmark for the

whole economy

• Only 7% of

pensioners have

an outstanding

mortgage

1

2

3

Standard Deviation:

•RPI 1.54

•CPI 1.02

Source: ONS

• (Reduce public pension liabilities...)

-2

-1

0

1

2

3

4

5

6

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

Risk management UK inflation - April 2011

• CPI jumped from

4% to 4.5% in April

• Currently remain

above forecasts of

4.1%

• RPI floats around

5.2%...

6


CPI up, 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

-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

30y Swap Real Yield 20y Gilt Real Yield 30y 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


Most Risk

Pricing mechanism

Least Risk

Sector

Availability Regulatory Demand Economic Price

Most Risk Least Risk

Source: Evolution Securities, Redington

Recap of bulk annuity market growth


Column: Stack

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

(£ million)Pension insurance

buyout / buy-in

Pension insurance buyout CAGR¹: 66%

Longevity insurance

Market growth maintained Transactions examples

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


RPI vs CPI Index: January 1988=100

75

100

125

150

175

200

225

1988

01

1989

01

1990

01

1991

01

1992

01

1993

01

1994

01

1995

01

1996

01

1997

01

1998

01

1999

01

2000

01

2001

01

2002

01

2003

01

2004

01

2005

01

2006

01

2007

01

2008

01

2009

01

2010

01

RPI rebased

CPI rebased

Expectations of RPI to CPI gap

15

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 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%

1989

09

1990

09

1991

09

1992

09

1993

09

1994

09

1995

09

1996

09

1997

09

1998

09

1999

09

2000

09

2001

09

2002

09

2003

09

2004

09

2005

09

2006

09

2007

09

2008

09

2009

09

YoY % increase RPI

YoY % increase CPI

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 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

17

RPI v CPI density function

18

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 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?


But general market movements more significant


• Affordability chart reflects approximate asset/liability mix of

the Scheme (c70% equities and 80% non-pensioners)

• Chart assumes scheme is fully funded initially – for an

underfunded scheme the volatility in the deficit will be much

larger

Our survey says...


Survey Results Audience

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:


16 participants

0%

10%

20%

30%

40%

50%

60%

70%

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

Proportion of matching assets

Survey Results Nationwide

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:


88 Actuaries, 19 Trustees

0%

10%

20%

30%

40%

50%

60%

70%

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

Proportion of matching assets

Actuaries Trustees


2. Broadly what proportion specify statutory minimum

revaluation/indexation, i.e. they could automatically move

to CPI:


16 participants

0%

10%

20%

30%

40%

50%

60%

70%

80%

<25% 25% - 50% 50%-75% >75%

"Statutory minimum" specified

Revaluation in deferment Benefit indexation in payment


3. For those that could automatically move to CPI, will those

Schemes move to CPI (rather than retain RPI):


16 participants

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Yes No

Proportion of schemes

Yes No


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

should move to CPI?


15 participants

Yes 67%

No 33%


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


5. What is your long term expectation for CPI inflation

relative to RPI inflation:


16 participants

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


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


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%

70%

80%

90%

100%

Buy-in or buy-out Longevity swap Liability Management

exercise

None Other

Unlikely Likely Almost certainly




3 years:



0%

10%

20%

30%

40%

50%

60%


Liability Management Exercise

Actuaries

Trustees




3 years:



0%

10%

20%

30%

40%

50%

60%

70%

80%

90%


Longevity Swap

Actuaries

Trustees




3 years:



0%

10%

20%

30%

40%

50%

60%

70%


Buy-in/Buy-out

Actuaries

Trustees

Survey Results


6. 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”

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?


Jay Shah

• Co-Head of Business Origination

• Pension Corporation

• [email protected]

• Tel: + 44 20 7105 2111

Robert Gardner

• Co-Chief Executive

• Redington

• [email protected]

• Tel: + 44 20 7250 3416

In addition...

http://twitter.com/robertjgardner

http://uk.linkedin.com/in/robertjgardner

Economy & Finance

Investment Implications of RPI to CPI