A vacation from (market-implied) inflation – the impact of the Retail Price Index

Here’s one legacy of the era of skyrocketing inflation that we saw in the 1980s: the vast majority of company pension schemes are now inextricably linked to the annual rise in the Retail Price Index (RPI). So, what impact has this had on pension liabilities?

In today’s world of ‘mark to market’, scheme actuaries typically use market-implied RPI to value pension liabilities at a particular point in time. The problem is that market-implied inflation has been, and will continue to be, overstated because of distortions in the market. One of the main reasons for these distortions is the relative undersupply of index-linked bonds which drives up their price and pushes down their yield. And the net result of this is clear: higher market-implied inflation.  

We’ve carried out retrospective analysis which shows that market-implied inflation rates have typically overstated subsequent actual inflation by 1% p.a. since the first index gilts were issued in 1981. So, what can be done about it? Well, if companies and trustees work together then what seemed impossible may be achievable.

In short, the company can issue a swap to the pension scheme that transfers the inflation risk from the pension scheme to the company balance sheet. This removes the third-party cost of the derivative. Collateral can be provided either using assets or cash so the trustees have reassurance on counterparty risk. Commercially, the swap has many of the characteristics of an asset-backed contribution (ABC).

The results are an immediate improvement in the funding position of the scheme without compromising the security of the trustees’ position. This can reduce the cash burden falling on the employer so it’s not prefunding for inflation at unrealistic levels. The additional cash can allow you to invest additional money in the growth of the business. And the swap can help to build a dialogue between trustees and the company around potential ways to reduce risk.  So, it’s a potential win/win for both the company and the trustees.

Chris Ringrose is a partner in our Pensions team. If you'd like to find out more about the impact of inflation on your scheme, you can contact him on  +44 (0) 113 289 4320 or by email at [email protected]