As a result, it will now account for the risk of mismatched inflation-hedging in its funding assumptions.
The UK lifeboat fund recently announced a 26% investment return, as assets hit £22bn (€31bn), but it said the likelihood of its being self-sufficient by 2030 had dropped by 2 percentage points to 88%.
In its ‘Long-term Funding Strategy Update’, the PPF explained the reasons behind the fall and updated a number of previous assumptions on investment strategy, recovery rates, longevity and inflation hedging.
The scheme’s inflation-hedging investments currently provide a return linked to the retail prices index (RPI); benefits, however, are linked to the CPI.
The RPI and the CPI became the UK’s most common inflation measures after the latter was introduced in 1989.
The government’s statistics office has since scrapped the RPI as an official measure, yet, despite this, UK Gilts and rent increases are often uprated by it.
“Over the past year,” the PPF said, “we have reconsidered our assumption that, eventually, a market in CPI-linked instruments will develop.
“Our inflation-linked liabilities are linked to CPI, but we now assume we will be only able to invest in assets that are linked to RPI.
“This assumption of non-emergence introduces a further risk into the margin, [as there is] a risk these two measures do not move in tandem, so our RPI-linked assets do not exactly track our CPI-linked liabilities.”
Between the creation of the CPI and October 2013, the index has been higher that the RPI for 56 months – 19% of the time on average, with the last occurrence in September 2011.
Were this to situation to reoccur now, the PPF’s hedging assets would fail to cover increases in liabilities, creating a shortfall.
The PPF calculated that a 70-basis-point drop in the spread between the RPI and the CPI would hit its chances of achieving its self-sufficiency target by 4 percentage points, adding £2bn of downside risk.
The lifeboat fund’s board said it would also review the impact of its new investment strategy of long-term illiquid assets providing inflation and interest cover.
The so-called hybrid asset class – which will account for 12.5% of asset allocation by 2017 – was brought in to reduce the scheme’s reliance on inflation and interest swaps.
This, however, means the scheme will not be free of investment risk by 2030, as is expected under the current self-sufficiency target, of which it is now 88% sure of success.
The PPF said holding hybrid assets would entail an asset allocation that failed to match liabilities perfectly beyond the 2030 target.
“We will consider including investment risk in our self-sufficiency risk margin when we have greater clarity on what our asset allocation may look like at and beyond the [2030 target],” it said.
The UK pensions industry has long called for more CPI-linked investment products, particularly from the government, as more schemes change indexation to the newer measure.