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Inflation Measures: Plus ça change, plus c’est la même chose

In the UK, 2015 started with a sense of déjà vu, as statisticians re-opened the debate on the merits of differing inflation measures.

In 2013, amid expectation the UK’s Office for National Statistics (ONS) would announce a new formula for the retail prices index (RPI), pension schemes hoped to see a reduction in their liabilities. However, the ONS introduced a new measure, a derivative of a widely accepted consumer prices index (CPI) – including housing costs – called CPIH.

In a report published this January, Paul Johnson, director of the Institute of Fiscal Studies, concluded that the government’s use of the RPI was defunct and that the official inflation figure should become CPIH, including Bank of England targets and the index for government debt.

The impact on pension funds is varied. While commentators agree the usage of RPI is outdated given its 300-year-old Carli formula, its use in contracts, government debt and pension schemes remains.

Over time, some UK schemes have amended pensions-indexation to CPI, following the trend in public sector pensions. However, many more face legal hurdles, causing a split among pension funds and inflation measures used.

Should the recommendations be taken on board, the UK government would stop uprating benefits and taxes and linking utility prices to RPI, with a potential knock-on effect for government debt, which could be issued linked to CPIH.

This would be welcome news for those offering CPI-linked indexation, assuming the difference between this and CPIH would be small. Current CPI hedging is limited, with exposure found in corporate bonds. Despite calls from the National Association of Pension Funds (NAPF), no CPI-linked government debt has been issued, with the Debt Management Office (DMO) suggesting demand has never been deep enough to consider it.

At the time of the 2013 announcement, AXA Investment Managers (AXA IM) disagreed with the DMO’s stance and argued that demand was plentiful given the amount of schemes with CPI indexation. However, if the government moves away from RPI-linked debt, it risks alienating those schemes that must still provide RPI-linked benefits.

“The decision between issuing CPI or RPI-linked Gilts should not be binary,” says Lucy Barron, senior solutions strategist in AXA IM’s liability-driven investments team. “Given that the majority of pension schemes also have part of their liabilities linked to RPI, and given the large supply and demand imbalance that exists already in this market as a result of long-term pension scheme demand for inflation-linked Gilts, it would be preferable for CPI-linked debt to be in addition to RPI issuance rather than fully in place of it.”

However, Barnett Waddingham, the UK consultancy, questioned whether the DMO would issue CPI linkers. Richard Gibson, an associate at the firm, says: “The DMO considered as recently as 2011 whether to move to issuing CPI-linked debt but decided not to do so – fearing there would not be enough demand from investors. It seems surprising this situation might have changed in only four years.”

However, one thing the measurement changes do not fix is the growing number of schemes looking for inflation-linked protection, with a split in the market between RPI and CPI (or even CPIH) making matters worse. A report from Pension Insurance Corporation (PIC), the specialist bulk annuity insurer, estimated that a £500bn (€650bn) shortfall in the supply of index-linked Gilts over the next decade would leave schemes unable to hedge risks. A complementary study by AXA IM predicted demand for index-linked paper would anchor real yields, keeping them in negative territory or around 0% for the foreseeable future

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