UK: Changes to pensions indexation
David Bennett outlines the implications of the UK government's decision to change the metric for pension benefit indexation. These are not as straightforward as some might have believed
The UK government's June emergency budget included proposals, with some exceptions, that consumer prices rather than retail prices will form the basis for uprating most benefits and public sector pensions. Following this, Steve Webb, pensions minister, said the government believes the same indexation metric should be used for all occupational pensions. This news caused quite a stir in the pensions community, and both sponsors and trustees are now pouring over their trust deeds and rules as well as member communications, in an attempt to understand how this might impact their schemes.
UK pension fund liabilities are linked to inflation in a number of ways - some discretionary, some statutory - in particular, the determination of the minimum revaluation of deferred pensions and increases in pensions in payment. Existing legislation includes several different inflation definitions, the most common being RPI with various caps (eg 2.5%, 3% & 5%) and floors (0%).
When the government made this announcement it probably believed it would result in a reduction of pension liabilities and an easing of pressure on sponsors. However, it made the announcement without any prior industry consultation and the implications are not as straightforward as the government might have believed.
CPI has on average been lower than RPI by 0.66% (year-on-year) since records began and structural factors mean this relationship should continue. However, cyclical factors mean that RPI has been below CPI for five years of the 22-year history, and it is quite possible that RPI will once again be lower than CPI in the future.
In the case of pensions in payment, if the new legislation specifies CPI as a minimum and the trust deed & rules specify RPI, one possibly unexpected historical outcome would have been higher liabilities, as indexation effectively becomes the greater of RPI or CPI.
This example clearly illustrates the potential challenge of implementing apparently simple changes to highly complex legislation. Sponsors and trustees will have to wait for the exact wording of the draft legislation before drawing any conclusions. It is likely that there will be considerable variation in the impact from scheme to scheme depending, for example, on whether the documentation specifically refers to the statutory minimum in the legislation or to RPI. In cases where RPI is either mentioned in, or implied by, the scheme's official documents or in member booklets and communications, it will potentially be very challenging to change to CPI.
Assuming that a scheme is affected by this change in indexation, a proportion of liabilities will then become linked to CPI (with caps and floors). This raises the issue of finding matching assets. Ever since the creation of the index-linked market in 1980, and more recently, the inflation swap market, schemes have used inflation-linked instruments to hedge inflation risk. The complexity of the liabilities (eg caps and floors) led to basis risk as the hedging instruments imperfectly match the liabilities.
The benefits of achieving ‘first order' inflation and real rate hedging have generally far outweighed mainly ‘second order' basis risks. The introduction of CPI-linked liabilities will now add new basis risks to what was already a complex situation, so schemes and their advisers will need to be resourceful in determining optimal asset allocation and hedging strategies.
Although banks are already quoting CPI/RPI basis swap pricing, there is effectively no significant market for those needing to hedge their newly-acquired CPI-linked liabilities. The UK's Debt Management Office (DMO) recently announced it had no plans to issue CPI-linked gilts in the near term, but would start consulting with the industry to ascertain whether they were needed and how they would be structured. Given that inflation definitions in the legislation are likely to continue to include caps and floors, there is the potential opportunity for CPI-linked gilts to be structured to address this, thereby minimising basis risk.
Should a CPI gilt/swap market develop alongside the RPI market, this could fragment the market with potential implications for liquidity, pricing and transaction costs, as the supply of RPI could decrease to make way for CPI issuance. Traditional providers may be slow to offer new products as demand for CPI-linked assets evolves but there are a number of alternative sources worth considering. Utilities, the retail sector, social housing and property leases all have revenues that are either directly or indirectly linked to CPI, or will potentially become so in the future. These can offer investors not only the possibility to hedge their CPI inflation risk but also gain exposure to attractive sectors of the economy.
As mentioned, there could be instances for schemes whose liabilities remain linked to RPI where a change to statutory CPI indexation increases liabilities. Hedging pensions in payment indexed according to a maximum of CPI or RPI would certainly be challenging.
Given that pensions indexation is an extremely complex area and draft legislation has yet to be published, the implications for private sector defined benefit schemes are highly uncertain. A significant effort will be required to determine the scheme-specific impact when the legislation is published and, as always, the devil will be in the detail. Even though historical data shows CPI inflation is below RPI on average, this ‘bonus' could be offset by the lack of appropriate CPI-linked assets. Likewise, for those whose liabilities remain linked to RPI, as a result of their trust deeds and rules, a change in indexation to CPI could potentially cause liabilities to increase if the CPI becomes a statutory floor.
Current hedging has typically focussed on first order inflation risk because of the complexity of existing indexation, with an acceptance of moderate basis risk. Should schemes acquire CPI-linked liabilities before a CPI bond or swap market has had a chance to develop, they will need to carefully consider the potential increase in basis risk inherent in hedging CPI liabilities with RPI-linked instruments.
David Bennett is a senior consultant with Redington in London