Pension funds should map out their exposure to inflation risk and develop policies to manage it, according to AXA Investment Managers.

With improving coverage ratios and a growing potential for indexation, inflation risk will also increase, Heiko de Boer, senior client relations manager at AXA IM, argued.

In a presentation at the annual congress of IPE’s Dutch sister publication Pensioen Pro last week, he said investors had been paying less attention to inflation risk in favour of managing interest-rate risk.

“However, inflation risk is crucial for the long term,” he said, “as many economists expect that inflation could climb to the [European Central Bank]’s target of 2%.”

He added that prices in the US have cumulatively risen by more than 40% during the past 17 years.

De Boer suggested setting up an inflation hedge similar to the the interest-rate hedges employed by many Dutch schemes. He recommended pension funds investigate whether they could replace part of their exposure to government bonds in their matching portfolio with inflation-linked bonds.

According to De Boer, these bonds could be used to manage both inflation and interest-rate risk. He emphasised that inflation-linked bonds were easier to deploy than inflation swaps.

He said research by AXA had shown that, if half of a 20% government bond allocation was replaced with inflation-linked bonds, the tracking error relative to real liabilities including indexation would drop significantly. The tracking error relative to nominal liabilities would only slightly increase.

In a scenario of rising break-even inflation of 0.35%, AXA expected that the bonds would deliver a surplus return of five percentage points during an eight-year period relative to nominal government bonds, according to De Boer.

He said inflation in the Netherlands would be an important criterion for an inflation hedge. However, as the Dutch state doesn’t issue inflation-linked bonds, pension funds should consider similar assets issued by other countries, drawn on inflation in the euro-zone.

Countries such as France, Germany, Spain, and Italy all issue inflation-linked bonds. De Boer suggested that pension funds look at French and German issuance if they preferred euro-denominated bonds, as the risk profile of Italian and Spanish inflation-linked paper was “too big”.

US inflation-linked debt was an alternative, he said, but a currency hedge – and possibly also a hedge of the US interest rate risk – would be necessary.

De Boer also recommended pension funds define both a nominal and an inflation-related benchmark – based on a pension fund’s cashflow – in order to manage interest rate risk as well as inflation risk.