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UK refusal to increase index-linked issuance 'creating risks' for pension funds

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The National Association of Pension Funds (NAPF) has repeated its call for the UK government to issue more index-linked Gilts and allow defined benefit (DB) schemes to provide a smoother run-off for members.

In a report, ‘DB run off: The demand for inflation-linked assets’, the industry group said UK DB schemes needed higher levels of index-linked issuance to effectively manage risk and the shift to liability-driven investment (LDI) strategies.

It said while derivatives, infrastructure and real estate all provided other options for inflation exposure, they were not suitable for all schemes.

The paper said, citing data from Towers Watson, that 50% of DB liabilities are hedged currently.

However, the NAPF expected demand of additional inflation-linked assets to reach £1trn (€1.2trn).

Some 40% of NAPF members said the appetite for index-linked assets was growing.

However, increasing demand for index-linked Gilts has pushed up costs for schemes, and lowered real yields.

Selected index-linked Gilts, with maturities ranging from eight to 31 years, all provided negative real yields for investors.

“Yields on index-linked Gilts have been on a declining trend for the past 20 years, making it more expensive for schemes to purchase them as part of a de-risking strategy,” the NAPF said.

“There has been increasing frustration from schemes that, in order to reduce their interest rate and inflation risks, they are effectively ‘forced’ buyers of Gilts with low or negative real yields.”

Extra issuance from the government was the only solution to aiding schemes hedge inflation risk in an appropriate manner, it said.

Alternative options, such as real estate and infrastructure, are less developed markets and have accessibility issues, with poor liquidity and volatility, making schemes reluctant to invest. 

However, the Debt Management Office (DMO), the department responsible for the issuance of UK government debt, issued £32.6bn of index-linked Gilts by the first quarter of 2014.

Overall, the bonds accounted for 22.9% of the Treasury portfolio, with £326bn issued.

Chief executive of the DMO, Robert Stheeman, told IPE that inflation-linked Gilts was a core part of its remit and that, in percentage terms, no other sovereign government issued as much.

“This time 10 years ago, we issued less than £10bn in linkers,” he said.

“Our supply of inflation-linked Gilts has dramatically increased, as have long-dated ones. We are very happy to issue, as we think it is very good value for money. But we cannot do this exclusively.”

The NAPF, alongside its call for greater issuance, said the government and investment industry must also ensure that inflation-linked opportunities outside of Gilts reach their potential.

“This will involve packaging these assets in a way that offers an attractive inflation match, improving levels of supply and offering pricing and valuation that is transparent and reliable,” it said.

Director of external affairs for the lobby group, Graham Vidler, added: “Unless the supply of assets is addressed, and quickly, the costs of providing member benefits could continue to rise and place even greater pressure on scheme sponsors.

“There is no quick-fix solution to the problem.”

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