While they may seem to offer better inflation-proof pension benefits, careful analysis shows that real contracts offer little more protection than nominal ones, argue Kees Bouwman, Theo Kocken and Bart Oldenkamp

Our analysis compares the effects of inflation and interest rate shocks on two pension funds with identical asset allocation, one of which implements a nominal contract while the other implements a real contract. For the sake of the analysis, both contracts are assumed to absorb financial shocks gradually, spread over a period of ten years. A decline of 10 percentage points in terms of funding rate then roughly translates to a 1% cut of pension rights or benefits over the next 10 years.

Both pension funds apply market valuation to their liabilities, with the real scheme applying a real discount rate curve. Sensitivity to inflation and interest rate shocks on the asset and liability side are expressed in terms of duration; so inflation duration, for instance, provides a measure of the sensitivity of assets or liabilities to inflation shocks.

For the nominal scheme, liabilities are assumed to have a nominal interest rate duration of 15 and inflation duration of zero.  With regard to liabilities in the real contract, nominal interest rate and inflation duration assumptions are 20 and -20 respectively. Realistically, expected or break-even inflation (BEI) will not respond to shocks as strongly as realised price inflation; BEI is therefore assumed to express shocks in realised price inflation at a rate of 2-3.

Liability duration in the real contract is higher than in the nominal contract as real liabilities are discounted according to a real interest rate curve, which generally will be lower than the nominal curve. For both contracts the researchers have assumed a nominal interest duration of five; finally, the assets are assumed to have zero sensitivity to inflation shocks resulting in inflation duration assumption of zero.

Figure 1 illustrates the effects of a financial shock comprising a 2% realised inflation hike and a nominal interest rate increase of 1%. For the nominal scheme, a 1% interest rate rise results in a decline of assets by 5 percentage points to 95 (as bonds decline) while the value of the liabilities, owing to a nominal duration of 15, decreases by 15 percentage points to 85. The net effect is a 10% rise of the funding rate which, when spread over 10 years, results in a 1% increase of pension rights.  

The effects on a real contract are somewhat more complicated. As in the nominal contract, assets will decline by 5 percentage points to 95. Due to the nominal duration of the liabilities of 20, liabilities will decline by 20 percentage points to 80. But expected inflation is taken into account in the valuation of real liabilities, so considering that BEI increases by 1.3% and inflation duration is 20, the inflation shock res ults in a 26 percentage point increase in liabilities, to a net value of 106.

Altogether, this leads to a -12% net effect on funding rate, which spread over a 10 year period amounts to a decrease of pension rights by -1.2%. As inflation compensation in real contracts is unconditional, the net result will be +0.8%.

Figure 3 shows the effects on pension rights of other nominal interest and inflation shock combinations. The results are obvious. First of all, real schemes do not offer inflation protection in situations where nominal interest rates are unchanged. This is due to the pronounced mismatch in terms of inflation sensitivity between assets and liabilities. Second, in cases of inflation shock where interest rates move in tandem, the ‘inflation capacity’ of both contracts is in fact largely comparable.

Kees Bouwman is financial engineer, Theo Kocken is group CEO and Bart Oldenkamp is Netherlands CEO, all at Cardano