What do inflation-linked pension benefit schemes and Texan cowboys have in common? We look at a source of scheme risk that many trustees may not have considered: limited price indexation risk. This could become increasingly important for trustees as their schemes progress along their de-risking glidepaths.
The sharpshooter fallacy is that a Texan fires some gunshots at the side of a barn, paints a target centred on the tightest cluster of hits and then claims to be a sharpshooter. The moral of the story is to be wary of false precision, particularly if the supposed target can be influenced by how success is measured.
What could this have to do with limited price indexation (LPI) pensions? A little background is needed. LPI pensions are inflation-linked benefits. For example, they might be pegged to the Limited Retail Price Index (0,5), tracking the rise in the inflation index — here the Retail Price Index (RPI). Each year, the potential loss is floored at 0% (i.e. members’ pension cannot reduce in pound terms) and the potential gain is capped at 5% (so the pension cannot grow more than 5% in a year).
There are other types of LPI but the year-on-year type is common. Essentially, LPI pensions present a risk management challenge to trustees. Many schemes choose to ‘delta hedge’ LPI pensions by dynamically changing their mix of RPI-linked and fixed assets. The fundamental idea is that caps and floors have a value due to the chance they need to kick in. As inflation expectations move, the value of the caps and floors changes. The aim is to hedge these changes in value by choosing a mix that moves in line. The question is exactly what this mix (or delta) should be.
Unlike the Texan sharpshooter, schemes will eventually get found out!
The delta is often based on a mark-to-market approach, using LPI swap rates. But this market has become illiquid and unrealistic in terms of its implied distribution of future outcomes, including suggesting that there is a very high chance of deflation. Indeed, this is why few schemes use LPI swaps in the first place. As a result, many schemes are switching to more ‘real world’ mark-to-model approaches to determine their delta hedges. The future behaviour of inflation is then based primarily on past behaviour, rather than on the price of illiquid instruments.
Houston, we have a problem
So, an illusion of precision can arise as an accident: trustees value LPI benefits using the same model as is used for the hedging strategy. Whilst this is a perfectly sensible thing to do, unfortunately it conceals an important risk: nobody knows the ‘right’ model for future inflation to use. In a similar way to how people disagree on real-world assumptions, such as equity risk premia, there is uncertainty and disagreement on the right model or assumptions for future inflation behaviour (such as inflation volatility). Whilst using a different model to determine your split of RPI-linked and fixed assets won’t manifest in the short-term — because movements in expected inflation dwarf lived experience to start with — it will be crucial in the long-run in terms of meeting benefits. In the long term, it is realised inflation that ultimately matters. Unlike the Texan sharpshooter, schemes will eventually get found out!
We’ve written an article where we’ve explored this issue – which we called LPI risk — in more detail. We explain how it may be an underappreciated risk. Once it’s accounted for, it can influence investment strategy, for example, by encouraging investors to take a pragmatic approach to rebalancing their delta hedge, and recognising an additional hurdle to cashflow matching benefits.