Expert View
TIME TO ACT ON HEDGING
INFLATION RISK?
You’re urging pension schemes to
think about hedging their inflation risk.
Daniel Peters, partner at Aon Hewitt,
asks why this risk has now come to the fore
T
BUT AREN’T THERE RISKS TOO IN HEDGING
AGAINST INFLATION?
Hedging inflation on its own does of course carry
risks. Schemes must keep in mind that there are
two components to hedging a liability; hedging
inflation, and hedging interest rates. You need
to do both eventually. Now is a great time to do
part one. If you don’t already have interest rates
adequately hedged, you must remember to come
back and do part two. We help clients understand
how much extra inflation risk they can hedge
compared to their interest rate risk.
SO WHEN SHOULD SCHEMES MOVE?
Right now – there’s a real opportunity for them.
Future inflation is uncertain – even the Bank of
England’s forecasts for the next two years paint
a very unclear picture – but the risk pension
schemes face is a real one. When we see short
term periods of deflation or concerns about
deflation as at the moment, it presents
opportunities to look at hedging long term
inflation risks.
Another consequence of the fall in the oil price
and inflation is that the Bank of England and the
US Federal Reserve are under less pressure to raise
interest rates to manage short term inflationary
pressures. While some schemes may be hesitant
to fully hedge their interest rates right now, we
believe they simply cannot afford not to increase
their inflation hedging.
WHAT OTHER OPTIONS COULD WE CONSIDER?
Other asset classes do give exposure to inflation.
These are often referred to as ‘real assets’ and
infrastructure is a good example. The main
drawback with these assets compared to an LDI
strategy is the speed of implementation and the
accuracy of the inflation hedge. An LDI strategy
will closely match pension liabilities and can be
put in place quickly and at relatively low cost.
iming, as ever, is vital. Short-term
inflation remains low and it’s driving
down the cost of the longer-term inflation
hedging assets used by pension schemes.
Inflation has been falling largely due to the
decline in the oil price. So, for a typical UK
pension scheme, where approximately 70-80%
of liabilities are inflation linked, this creates an
opportunity to remove risk, as the cost of buying
the assets needed to hedge future inflation has
also come down.
ENGAGED INVESTOR MARCH / APRIL 2015
Daniel Peters
partner
Aon Hewitt
20
“LDI
mandates
enable
schemes
to use
inflation
swaps to
pay a fixed
rate of
inflation”
BUT CAN YOU SEPARATE INFLATION RISK FROM
INTEREST RATE RISK?
Yes - since inflation started falling, we have
advised more and more schemes to separate their
inflation risk from interest rate risk by increasing
their inflation protection. LDI mandates enable
schemes to use inflation swaps to pay a fixed rate
of inflation, and receive whatever inflation turns
out to be – at the moment this fixed rate looks
attractive. This allows trustees to isolate the
inflation decision and doesn’t tie up capital in the
same way that a regular bond portfolio would.
SO HOW DO SCHEMES GO ABOUT THIS?
From a practical perspective, schemes which want
to increase their inflation hedge in isolation –
without hedging interest rates – will need to have
a liability driven investment (LDI) mandate. Other traditional hedging assets such as a regular
bond portfolio and index-linked gilts, just don’t
allow schemes to separate the return linked to
interest rates from the one linked to inflation.
By contrast, liability-driven investments offer
schemes the opportunity to single out the
inflation component and to benefit from the
cheaper current market conditions.
IS IT REALLY WORTH THE HASSLE?
We did some analysis last year which suggested
it was a good time for pension schemes to hedge
against interest rate risk. Schemes which did not
act to bolster their hedge at the time may now
be feeling the cost of being under-hedged by
approximately 20% in funding terms – which
shows just how sensitive pension scheme
liabilities are to movements in interest rate risk.
While expectations remain low and hedging
assets look cheap, inflation risk – just like interest
rate risk – should be addressed to reduce any
threat to the stability of the scheme.
The recent drop in the oil price and the
knock-on impact on short term inflation prospects
has provided the cue for pension schemes to look
at hedging their exposure to inflation. Even if
pension schemes are not acting on interest rates
at the moment, this is worth looking at. But one
thing is essential; it needs to be an LDI mandate
in order to take advantage of inflation pricing.
Physical bond mandates simply won’t do the job.