Investment Implications of RPI to CPI Switch

© 2010 The Actuarial Profession  www.actuaries.org.uk
Robert Gardner, Redington
David Collinson, Pension Corporation
Investment Implications
of RPI to CPI
13 March 2012

The Inflation basket
1© 2010 The Actuarial Profession  www.actuaries.org.uk
RPI:
+ Financial Services

RPI vs. CPI
Why it’s happened
• CPI is BoE’s
benchmark for the
whole economy
• Only 7% of
pensioners have an
outstanding
mortgage
•(Reduce public
pension liabilities...)
1
2
3
Standard Deviation:
•RPI 1.58
•CPI 1.15
Source: ONS
-2
-1
0
1
2
3
4
5
6
Jan
2000
Jan
2001
Jan
2002
Jan
2003
Jan
2004
Jan
2005
Jan
2006
Jan
2007
Jan
2008
Jan
2009
Jan
2010
Jan
2011
Jan
2011
Percentage
RPI (y/y) CPI (y/y)

How it’s happened
Public sector
• Pensions in payment increases indexed to CPI,
• capped at 5%
Private
• No mandatory statutory override
• No enabling modification power
• No CPI underpin required
• New pension consultation requirement

Risk management
UK inflation – the long run
Long run difference
• Aggregate price changes
• Mathematical formula
• 2010 formula effect to
persist
• Permanent 0.3% difference
implied
• Long-run estimate of 1.2%
“wedge”.
Formula effect
Source: ONS

• Sharp fall in both
RPI and CPI since
September 2011
• RPI at 3.9% in
January vs. 3.6%
for CPI
• Spread at narrowest
since early 2010
Risk management
UK inflation - January 2012
CPI and RPI down
Source: ONS, Redington
0
1
2
3
4
5
6
Percentage
RPI (y/y) CPI (y/y)

Risk management
Hedging inflation
Finding relative value
Source: Bloomberg, Redington
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
%
30-Year Gilt Real Yield 30-Year Swap Real Yield Swap Spread (Swap Yield - Gilt Yield)

Risk management
Hedging CPI Swaps Pricing*
• 20 year RPI 3.475% - 3.575%
• (Mid – 3.525% and 5bp spread)
• 30 Year RPI 3.927% - 3.655%
• Vs
• 20 year CPI 2.852% - 3.252%
• 30 Year CPI 2.927% - 3.327%
RPI/CPI spread
• 20 year CPI Mid – 3.052% and 20 year RPI
Mid – 3.525%
• = -0.473% with at least 20bps spread.
• 30 year CPI Mid – 3.127% and 30 year RPI
Mid – 3.605%
• = -0.478% with at least 20bps spread.Source: RBS

Risk management
Hedging inflation
Hedging CPI
Physical assets
• CPI-linked gilts?
• Flight Plan
Consistent Assets
(FPCA)
• CPI bond market...?
CPI

Risk management
Alternative Sources of CPI
-6
-4
-2
0
2
4
6
8
0 5 10 15 20 25 30
GBPMillions
Years
Initial investment
Attractive real returns
Inflation-linked cashflows
Providing a match for liabilities
Inflows
Outflows
Source: Redington
Flight Plan Consistent Asset – Example Cashflow Profile

Risk management
Alternative Sources of CPI
Source: Evolution Securities, Redington
Most RiskLeast Risk
Inherent
Sector Risk
Pricing
Mechanism
Satellites Generation
Ports
Environmental Renewables Airports
Storage Pipelines
Distribution Masts
Water Transmission
Bridges/Tunnels Rail
Defence Roads Transport
Education Healthcare
Social Housing

11
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
2004 2005 2006 2007 2008 2009 2010 2011
Forecast Q4 2011
Longevit y Swaps
Pension Insurance buy-out
Development of the insurance market for
pensions in the UK since 2004
Source: PC analysis, LCP Buyout Report 2010, Hymans Robertson 2010 and H1 2011
Update
1) 2009 figures include £1.9bn RSA longevity transaction completed in July 2009

Reaction of schemes looking to de-risk
• How does this impact us?
– In payment : RPI generally hard-coded
– In deferment : reference to statutory revaluation
• ETVs and PIE exercises put on hold
• Buy-in / Buy-out decisions delayed

Pension scheme view of CPI vs. RPI

Expectations of RPI to CPI gap
14
Party / Source RPI-CPI assumption
The Office for Budget Responsibility, Economic and
Fiscal outlook of March 2011
1.2%
FTSE350 Pension Fund accounting disclosures,
Hymans Robertson’s 2011 survey
0.7% to 2.8%
Mercer briefing July 2011 0.5% to 0.8%
Investment Bank instruments 0.1% to 0.2%
Our survey See later slides

Insurer view of CPI vs. RPI

RPI v CPI: Historic differences
• The average annual RPI-CPI gap from May 1997 to July 2011 was 0.88%
• Annualised standard deviation of monthly observed RPI-CPI basis was
1.27%
• RPI was above CPI for 85% of the period
– Main period of negative RPI-CPI due to rapid mortgage cost inflation
reduction over 2008
16

RPI v CPI density function
17
Histogram of RPI-CPI since May 1997 and approximated density function
Abnormal – e.g. falling interest rates
mean of – 2.9% (CPI higher)
Normal : mean of 1.1%
(RPI higher)

RPI vs. CPI – stochastic simulation – no
underpin
Source: Barrie and Hibbert

RPI vs. CPI – stochastic simulation – with
underpin!
Source: Barrie and Hibbert

CPI, RPI and base rates

Hedge with RPI – implications for insurers
• 1 in 200 year test – capital requirements
– statistical variation
– changes in the basket of goods
– changes in calculation methodology
– political influence
• Shock effects if CPI market develops differently
• Impact of caps and floors:
– Volatility of CPI is lower than RPI
– So floor and cap both less likely to bite? Net impact?

Hedge with CPI
• Investment Bank A : CPI vs RPI = 0.1%
• Investment Bank B : CPI v RPI = 0.2%
• Capacity available : Small
Instrument Approx market size
Indexed RPI gilts £270 bn
Indexed RPI bonds £30 bn
RPI Inflation swaps £100 bn
CPI linked Virtually nil

Insurer solutions
• Insure on CPI but small discount to RPI
– Benefits indexed to CPI
– Expected CPI under-run
– Offset by cost of risk capital
• Option to move from RPI to CPI in future
– In anticipation of CPI market opening up in future
– Part refund of premium
– To whom – scheme or company
– On a buy-in or buy-out?
• Differential pricing?

But general market movements more significant
• Chart shows ‘overall affordability’ for a scheme with a blend of deferred and pensioner liabilities, and
invested in a 55% equities / 45% bonds mix. ‘Affordability’ considers the cost of insuring the pension
risk compared to the value of the assets held by the scheme. A higher value in the index means that
insurance is more affordable for pension schemes (insurance costs have fallen and / or asset values
have risen)
• Bulk annuity affordability plunged during the second half of 2011, primarily due to ultra-low Gilt yields,
but equities also dragged down funding positions
50.0
55.0
60.0
65.0
70.0
75.0
80.0
Fundinglevelin%
Affordability

Redington – Pension Corporation Survey
112 Actuaries and Trustees between May and October 2011
• Overwhelming majority of schemes vulnerable to future
inflation increases
• Less than 20% of defined benefit pension schemes surveyed
had at least 50% of their inflation-linked pensions backed with
inflation-linked assets such as index-linked gilts
• General inflation risk a much greater risk to most schemes
than CPI/RPI basis risk
Key Findings / Conclusions

Survey Results
1. What proportion of inflation-linked liabilities are matched
with inflation hedging assets such as index-linked gilts,
inflation swaps or buy-in insurance policies:
Based on responses from 88 Actuaries
and 13 Trustees
0%
10%
20%
30%
40%
50%
60%
70%
0% - 25% 25% - 50% 50% - 75% 75% - 100%
Proportion of matching assets
Actuaries Trustees

Survey Results
2. To Trustees: Does your scheme specify statutory
minimum revaluation / indexation, i.e. could the scheme
automatically move to CPI?
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Yes No
"Statutory minimum" specified
Revaluation in deferment Benefit indexation in payment
Based on responses from 21 trustees

Survey Results
3. To Trustees: Will your scheme move to CPI (rather than
retain RPI):
Based on responses from 20 trustees
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Yes No
Proportion of schemes
Revaluation in deferment Benefit indexation in payment

Survey Results
4. In your view is it fair that schemes that can move to CPI
should move to CPI?
0%
10%
20%
30%
40%
50%
60%
70%
80%
Yes No
Actuaries
Trustees
and 23 Trustees

Survey Results
5. What is your long term expectation for CPI inflation
relative to RPI inflation:
0% 10% 20% 30% 40% 50% 60% 70% 80%
Same as RPI
c.0.5% p.a. less than RPI
c.0.5% to 1% p.a. less than RPI
1% to 2% less than RPI
Actuaries Trustees
and 23 Trustees

Survey Results
6. Of possible de-risking options, which of the following do
you think your schemes consider seriously over the next
3 years:
0%
10%
20%
30%
40%
50%
60%
Unlikely Likely Almost certainly
a. Liability Management Exercise
Actuaries
Trustees
and 22 Trustees

Survey Results
3 years:
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
b. Longevity Swap
Actuaries
Trustees
and 21 Trustees

Survey Results
3 years:
0%
10%
20%
30%
40%
50%
60%
70%
c. Buy-in/Buy-out
Actuaries
Trustees
and 23 Trustees

Survey Results
d. Other:
“Journey planning / flight path / de-risking triggers”
“Phased buy-in, via annuity purchase when members retire”
“Closing to future accrual (for those few schemes still open)”
“Increase in LDI assets”
“Winding up”
“More bonds”
3 years:

Survey Results
7. What impact has the CPI move had on schemes
considering de-risking?
“Little / None”
“Potential reduction in Buy-out cost. Slightly more scope to exchange
pension increases. Some offset CPI gains through lower risk investment
strategy”
“Caused delays to some looking at buy-in/out because insurers have
been unable to provide CPI pricing”
“As far as I am aware [public sector schemes] are not looking to derisk,
other than via wholesale benefit changes following Huttons report”

Questions or comments?
David Collinson
• Co-Head of Business Origination
• Pension Corporation
• collinson@pensioncorporation.com
• Tel: + 44 20 7105 2110
Robert Gardner
• Co-Chief Executive
• Redington
• robert.gardner@redington.co.uk
• Tel: + 44 20 7250 3416
 In addition...
 http://twitter.com/robertjgardner
 http://uk.linkedin.com/in/robertjgardner

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