As a result of last year’s unfavourable investment returns and relatively high inflation some pension funds in the Netherlands have decided not to index their liabilities for inflation. Inflation represents the foremost risk factor for pension funds. For example, a one percentage point higher inflation expectation increases the market value of liabilities by approximately 17% due to the long duration of the liabilities and increases the risk of being underfunded substantially.
Normally one conducts an asset/liability study based on traditional asset categories such as bonds and equities in which bonds give some compensation for the inflation and equities an extra return that can be seen as hedge against inflation. Since the introduction of the euro, bonds no longer offer compensation for Dutch inflation, which has been distinctly higher than euro inflation. In search of a good hedge against inflation other categories have been researched, such as real estate and commodities, but these do not really offer a direct hedge against inflation; the annual correlation with inflation is quite low (see table). We cater to institutional clients (pension funds) that have liabilities linked to the Dutch inflation (defined benefit) and ask the question: “what instruments are available for our clients that give a direct hedge against inflation?”
Each year liabilities will grow by the inflation of the previous year. Inflation will be partly due to wage increases and partly due to consumer price index; the correlation between both inflation figures is 0.9 over the period 1970–2001. In the Netherlands the rent of commercial real estate (that is, real estate other than housing) is also directly linked to the inflation. Each year the rent is increased by the inflation index (CPI) of the year before. The return on real estate can therefore be split into three parts:
q the market valuation of real estate;
q the initial rent;
q the future inflation indexing of rent. Important to note is that in both cases the inflation is cumulative (see figure). For example, due to the cumulation of inflation, the real estate cash flow from inflation in the fifth year will be e14 on an initial rent of e100.
If it was possible to ‘strip’ the inflation from the real estate, one would be able to create a perfect hedge for the inflation risk in liabilities. The major challenge is how to avoid the risks in connection with the underlying real estate during the period that inflation cash flows are to be received, or, to put it more directly, how to receive an inflation cash flow preferably without or with low credit risk.
Together with Inflation Exchange Fund (IEF) and Bouwfonds, we have achieved this goal by creating a structure in which all interests come together. The structure allows the real estate owner to obtain an attractive source of funding: the discounted cash flow value of the future inflation cash flows. It supplies the bank with certain guarantees. For example, each year a certain proportion of the principal amount of the loan will be amortised. The amortisation creates a kind of collateral for the inflation payments. The total structure has been stress-tested for several factors such as high inflation rates and high vacancy rates.
Another issue is the liquidity risk: there is no secondary market for the contractual rights of the inflation buyer. Of course, this risk is reflected in the price of the contract (liquidity premium). One could argue that institutional inflation buyers, with long-term goals, would pursue a buy- and-hold strategy and will not mind the liquidity issue. On the other hand it is possible to raise the structure to the level of bank status issuing inflation coupons that are investment grade (as rated, for instance, by Standard & Poor’s or Moody’s). Thus, investors know what risk is associated with the continuity of the cash flow that they buy and they should be less worried about the state of the underlying structure.
Inflation-linked bonds are an alternative instrument as a hedge against liabilities. However, at the moment there are no inflation-linked bonds linked to Dutch inflation. Only euro inflation-linked bonds are available in the market. It is possible to buy a cumulative inflation swap with a bank as counterparty. However, here credit risk is also an issue to address. Moreover, the pricing is less favourable due to the liquidity of the market. The bank as intermediary faces the same problems as discussed in our implementation. If all pension funds in the Netherlands would incorporate inflation products for 10% of their portfolio, then the buy-side of the inflation market would be around e50bn. It is obvious that the available instruments do not cover the demand for inflation.
Incorporating the inflation contracts as described in the ALM analysis leads to the following observations. The risk, measured as the probability of a funding ratio below a pre-specified level, decreases substantially at the same level of contribution. This implies, for example, that incorporation of inflation contracts enables a pension fund to invest more in high-risk investment categories at the same total level of risk. The allocation to inflation contracts decreases the allocation toward bonds. The optimal allocation is in our view quite substantial (>10%), although we think that it is too costly (in terms of opportunity costs of not investing in equities, for example) to hedge all the inflation risks.
For our largest client, the third largest Dutch pension fund, the fund for the metal and technical industries BPMT, we were able to buy inflation as described above. We are still looking at possibilities to invest in inflation, for existing and new clients. At present the structure described above seems to offer the ‘best buy’ given the alternatives.
Jan Bertus Molenkamp is director, investment strategy, at Mn Services in Rijswijk