When is hedging attractive?

Most pension schemes now incorporate some element of liability management into their long-term strategy. Deciding whether conditions are favourable for such a strategy can be difficult, but looking at the Bank of England’s Quarterly Inflation Report (QIR) can help, as this is used to help form interest rate decisions.

The QIR is particularly relevant for pension schemes because of the impact monetary policy has on long-term interest rates and inflation rates.

■ Long-term interest rates can be thought of as an average of the expected path of short-term interest rates, adjusted for a risk premium.
■ Long-term inflation rates can be thought of as an average of the expected path of short-term inflation, again, adjusted for a risk premium.
The February 2014 QIR gives us an insight into current MPC thinking and allows us to draw implications for both interest rates and inflation.

Interest rates may remain low

With the base rate at an historic low, and long-term rates still near historic lows, there is a perception that all rates will have to increase from current levels. In the recent QIR, the Bank noted that the Bank Rate is “is likely to be materially below the 5 per cent level” over the medium term.

In fact, we believe that base rates could remain below 4 per cent for some time. Firstly, we expect growth to be lower over the next few years than was the case before the financial crisis. In addition, given the historically high level of consumer debt, we believe that the MPC will be cautious about raising rates and thereby affecting demand.

This expectation is already reflected in long-term rates and can be seen by looking at gilt forward rates, which are around the 4 per cent level or even slightly lower at longer maturities of 30 years or more, reflecting strong demand from long-term investors such as pension schemes. There is no reason to expect this demand to abate and this will help limit any increase in long-term rates.

Inflation

The QIR explains how the BoE expects the difference between CPI and RPI inflation (generally referred to as the RPI CPI wedge) to play out. The Bank expects the long-term wedge to be in the region of 1.3 per cent - or that RPI will remain around 1.3 per cent higher than CPI in the long run. This reflects differences in how these are calculated, as well as slightly different components in each, most notably the housing-related components featured in RPI but not CPI.

If the BoE meets its inflation target then this implies an RPI rate of 3.3 per cent (the 2 per cent CPI target plus the 1.3 per cent wedge). As central banks generally have a preference to avoid deflation, it can be argued that there is a greater risk of CPI inflation surprising on the upside than on the downside in the longer term. With long-dated swap rates at around 3.6 per cent this gives a relatively small risk premium but, for pension funds looking to remove inflation risk, it may be the case that the accompanying risk reduction is worthwhile.

What this means for hedging

Long-term interest rates look reasonable given current market dynamics and recent comments from the Bank of England. Long-term inflation levels also look reasonable based on the CPI inflation target and an RPI CPI wedge in the region of 1.3 per cent (assuming a stable level of interest rates).

Consequently, we believe that hedging liabilities at current market conditions, or building up hedges at fixed intervals through ‘averaging in’, remains a sensible risk management strategy, which provides more certainty for a pension scheme’s journey plan.

At the same time, there is no right answer for every pension scheme and the optimal amount of hedging will vary by client. For example, very well hedged clients may feel more able to take a view on the outlook for interest rates in the knowledge that a bad outcome will not materially impact the continued ability to meet pension benefits.

Laura Brown is head of LDI distribution, Legal & General Investment Management

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