Pension scheme inflation hedging activity slows as industry awaits RPI reform clarity

Inflation hedging activity amongst UK pension schemes was held back by uncertainty around retail price index (RPI) reform during Q3 2020, according to the latest BMO Global Asset Management LDI survey.

The research, which polled investment trading desks on the volumes of quarterly hedging transactions, found that inflation hedging activity had decreased by 13 per cent quarter-on-quarter to approximately £34.4bn.

Interest rate hedging meanwhile, has remained steady quarter-on-quarter.

The firm also noted that swap-based hedging had “surprisingly” continued in reasonable volumes, despite pension funds’ bias towards gilt-based hedging and the current abundance of repo balance sheet.

Commenting on the findings, BMO Global Asset Management LDI portfolio manager, Rosa Fenwick, added: “There were a few key themes to hedging activity this quarter.

"Firstly, the lower volatility in relative value spreads reduced that form of opportunistic trading. The resurgence of buy-out activity in September offered liquidity to those seeking to transition more towards gilt-based hedging.

“There was also a continued interest in cashflow driven investment (CD) -based strategies, which served to reduce demand for gilts, whilst negative rate expectations removed the floor from nominal yields and encouraged pension funds to target their optimal hedge rather than holding off for more attractive entry-levels.”

The research also asked investment bank derivatives trading desks for their predictions on the future direction of key rates for pension scheme liability hedging.

It found that whilst Q4 has typically been strong for hedging flows, predictions for inflation activity remain nuanced, with an almost even split as to whether it is expected to rise or fall in Q4 2020.

Those who predicted a fall in inflation focused on the the resolution of Brexit concerns and that a full alignment of RPI to the Consumer Price Index including owner occupiers’ housing costs (CPIH) is not priced in.

Meanwhile, those expecting an increase cited the lack of supply versus expected LDI demand, as well as the delayed response to the RPI reform, with the government consultation having been extended amid Covid-19.

The results of the consultation on the reform of RPI are expected towards the end of the month, with Legal & General Investment Management recently highlighting the reform as the “next major event risk” for defined benefit (DB) schemes to navigate.

Industry experts have previously warned that the reforms could leave pension schemes around £80bn worse off, and cost savers and investors up to £122bn, with the shift expected to impact 10 million DB savers.

Previous research has also warned that those schemes who took steps to hedge inflation risks could be "the worst hit" by the changes, with a potential 12 per cent fall in funding levels.

Commenting on the news that the findings of the consultation are expected this month, Insight Investment head of solution design, Jos Vermeulen, stated: "In what has already been an extremely challenging year for the public and corporates, aligning RPI with CPIH, as per the proposal, will cause further misery for pensioners and sponsors of pension schemes with CPI-linked liabilities.

"Market pricing suggests a very high probability that the proposal to fully align RPI with the CPIH will go ahead, however a fair and equitable outcome can be achieved if RPI is aligned with CPIH plus an appropriate margin to ensure that there are no resultant losers.

"We hope that the UK Government and UK Statistics Authority has given careful consideration to the economic consequences of RPI reform before making a final decision and that they have listened to the broad community of stakeholders who participated in the consultation process earlier this year.”

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