An inflation risk premium (IRP) is nothing new. Market-implied inflation has historically been higher than actual realised inflation. There is only a limited supply of inflation-linked assets and investors have, up until now at least, been willing to pay a premium to get their hands on them. As an example, if market-pricing implies inflation is 3% in 20 years, but we actually expect it to be 2%, then the inflation risk premium is 1%.

Over the last year the level of IRP observed in the market has widened significantly – to the extent that investors should be questioning whether it still represents a price worth paying to reduce the inflation risk that is sitting on the other side of the balance sheet.

What is driving the increase?

Two things, mainly:

1. Short-term inflationary pressures as economies open up from covid restrictions, the supply of goods struggling to meet demand, and more recently the rising cost of energy;
2. The planned alignment of RPI with CPIH from 2030. The Bank of England (BoE) target for RPI is 3% and CPI is 2% (CPI and CPIH are closely aligned).

The combination of these two factors means that market-implied inflation is suggesting RPI in 2030 will be approximately two times the BoE target of 2% at this time. Whilst current inflationary pressures are undeniable, nobody knows what inflation will be in 2030, so inflation pricing closer to the 2% BoE target doesn’t feel unreasonable.

What are the implications for pension schemes?

Understandably, the IRP has crept onto trustees’ agendas over the last year or so. Historically, stakeholders have accepted that market-priced inflation includes an IRP, but have not adjusted for it. This approach effectively results in additional prudence within a valuation basis. 

Now that the IRP has widened, sponsors and trustees may find market-implied inflation harder to justify and a “best estimate” inflation assumption approach is an option on the table. Possible approaches are to either assume a fixed inflation level (that is lower than what markets suggest) or to apply a deduction to market-implied inflation in a manner than seeks to remove the IRP.

In isolation, this would likely serve to improve funding today for most schemes, although remove an element of prudence and the associated incremental funding gains. However, that would otherwise have expected to come through over time from actual inflation being lower than that assumed in the valuation basis.

This is demonstrated in the illustrative example below.

(Click image to enlarge)

The impact of allowing for an IRP will vary between schemes depending on several factors, including:

• The level of inflation-linkage within the liabilities;
• The size of the IRP allowed for; and
• The level of inflation hedging in place.

In respect of the latter, any assumed IRP will need to be reflected on the asset side in an offsetting manner – if inflation-linked liabilities are now assumed to be lower, then inflation-linked assets must be treated in a similar way.

Things to consider

Allowing for an IRP has several implications for schemes, some of which we have set out below:

• Funding increases today. Where there is a deficit, this may lead to lower sponsor contributions compared to if no allowance was made for an IRP but this may result in lower security for members.
• Changes in liability hedging will impact the size of IRP that can be allowed for. Any allowance for an IRP on liability measurement should be met by an equivalent assumption for inflation-linked assets. Funding levels may therefore change following a change in inflation hedge ratio.
• Liability inflation caps and floors. Inflation caps and floors impact the proportion of liabilities that are assumed to be linked to inflation which in turn may impact the size of IRP that can be allowed for.
• Rationale for removing/reducing the IRP assumption. Given an IRP will likely always exist to some degree, there is a question mark over how far inflation pricing needs to fall in order for it to no longer be allowed for a liability estimate and vice versa to reintroduce it.

What does all of this mean?

The appropriate treatment of an IRP is a tricky topic. There is no definitive right or wrong answer. What matters is that trustees understand the direct and indirect impact of allowing, or indeed not allowing, for an IRP. This includes the impact on hedging and funding.

If you have any questions on anything covered in this blog, or how IRP will affect your schemes, then please get in touch.