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- Con Keating
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- Jon Spain
On 12 May 2023, Henry kindly published a piece we wrote, querying why index-linked gilts had been so firmly recommended by TPR and consulting actuaries. No one has responded, which is interesting in itself. Anyway, that question was partly sparked by our joint website ukrpi.com, which we’ve been running for around 15 years, which we think worth describing.
For long-term DB pension funding, it has been very common for UK actuaries to estimate future long-term RPI inflation by comparing yields on conventional gilts (“CGs”) with those on index-linked gilts (“ILGs”). The point of our website is to show that this doesn’t work
Why have actuaries done that? Yes, we can see the “logic” but where, if anywhere, was that recommended or suggested? Having asked around, no one seems to know. Although we had thought it was mandatory for PPF §179 assessments, that is not the case (see original guidance from 2005). For FRS17, there is merely a strong steer in section 26, without any reference to duration for inflation. While IAS19 has mostly swept FRS17 away, we are unaware of any further relevant guidance. Given that yield curves tend to slope upwards, that does beg questions. While similar outstanding terms may seem logical, maturity may be more of a problem than has generally been observed. After all, the ILG “duration” must be longer than for conventional gilts because the return is very much more heavily weighted towards capital.
The rationale appears to be that gilts of either kind should deliver broadly the same return over a long period and that the difference represents the allowance for inflation. On performance, over periods of 15 years, ILGs have performed marginally better than CGs, by a mean margin of 0.3% pa. Over short periods, the out-performance has been the reverse. We thought we should test the inflation approach against reality, which we started in around 2008.
In fact, we have found that the standard approach hasn’t worked at all well. As an example, take the 15 years from Dec 1990 to Dec 2005. In 1990, the expected inflation was 6.8% pa, against actual inflation measured in 2005 of 2.7% pa, a colossal difference of 4.1% pa, the highest observed. Using annual readings between 1985 and 2022, the mean difference between estimate and actual was an over-estimate of 1.2% pa (standard deviation 1.4% pa).
We have also looked at what might be a sensible estimate of the difference between RPI increases and CPI increases over periods of 15 years. For at least several years, we have read and heard it claimed that the long-term difference is equivalent to 1% pa. Comparing RPI with CPI over 1 year, the average has been 0.78%, with a standard deviation of 1.07%. As it occurs at the 60th percentile, it is not unreasonable to suggest that the expected difference could be as high as 1%. However, comparing RPI with CPI over 15 years, the average has been 0.72% (very similar to that over 1 year), with a much lower standard deviation of 0.10%. A value of 1% would be 2.8 standard deviations away from the mean, which corresponds to a likelihood of 1 in 200, namely highly unlikely; 1% really cannot be taken as a best long-term estimate.
The website has a number of charts and we do look at CPI and CPIH as well as at RPI. Further, we have also tracked Bank of England yield curves, which, overall, seem to be rather better than using gilts in a simplistic basis. If anyone feels that we have misstated how actuaries estimate inflation, and how they have been generally encouraged to do so, please tell us.
LongTermInflationEstimates_ConAndJon_14Jul2023.docx
Two excuses I have heard from actuaries over the years are (1) that there is a floor in pensions increases of 0% even if RPI and/or CPI can be negative in certain periods, and (2) that there is a liquidity premium in gilt markets which varies over time.
Observers of larger company accounting disclosures in the UK have tended to see a wider range of different assumptions being used than is the case with discount rates based for accounting on AA bond yields.
Many companies also seem to deduct a modest “inflation risk premium” whatever that means, presumably tied in with my earlier reference to a liquidity premium?
IFRS guidance (see https://www.ifrs.org/content/dam/ifrs/publications/pdf-standards/english/2022/issued/part-a/ias-19-employee-benefits.pdf)
seems to be that “An entity determines the discount rate and other financial assumptions in nominal (stated) terms, unless estimates in real (inflation-adjusted) terms are more reliable, for example, in a hyperinflationary economy (see IAS 29 Financial Reporting in Hyperinflationary Economies), or where the benefit is index-linked and there is a deep market in index-linked bonds of the same currency and term.”
You seem to be implying the UK’s market is not a deep market?
Once again Con and Jon bring attention to a matter that has been troubling me. As a trustee I have been long concerned about basing an inflation assumption on a comparison of the yield between index linked gilts and conventional gilts of a similar maturity.
My main concern is that the yields are both determined by market prices which reflect the relative demand for each product. Yet they are not similar products: CGs pay-out a known annual stream of income and a terminal payment of the historic nominal value; whereas with ILGs there is little or no annual interest and the Government’s promise is the payment of an inflated capital repayment at maturity. It is therefore likely that there is a fundamental difference in the market for each, with income being the dominant objective with CGs and sale proceeds the dominant objective with ILGs. Unless you are holding the ILG to maturity the sales proceeds will themselves be largely determined by market factors at the time of sale.
With pension schemes being dominant investors in both markets, the outcome is that CGs are attractive to mature pensions schemes seeking an income flow to match their pensions outflow whether DB or DC.
ILGs on the other hand should theoretically be of interest to open pension schemes who are able to meet pension outflows with new contributions or have sufficient other income flows to tide them over to maturity. The majority of ILGs in issue have maturity dates beyond 2040, up to 2073, whereas I understand the average duration of a closed pension scheme’s liabilities is around 15 years, so even on this basis there is a mismatch between supply and demand.
ILGs should not be of interest to the decumulation phase of money purchase arrangements and during the accumulation phase would be purely a speculative investment .
In the situation where a significant proportion of the defined benefit pension schemes are targeting a buy-out (or even a buy-in) within a short timeframe, it appears there is likely to be an excess of sellers over buyers for longer dated ILGs. (It looks as if the buy-out of the BP pension scheme alone would release $12BN of ILGs onto the market) This will force down prices and increase yields. If there is not the same mismatch between buyers and sellers in the CG market, the differential yield will widen and the inflation assumption will rise.
There is also a systemic risk that existing holders of ILGs seeing the fall in market prices will be concerned about their ability to realise the capital value of their holdings (whether pre or post buy-out) and seek to exit the market.
The fundamental issue for DB pension schemes is that so much emphasis is placed on valuations comparing the capital value of their assets to a single supposed liability figure entirely based on speculation assumptions about the future which are given undue credence by actuarial guidance which does not really question the fundamental bases on which those assumptions are based.
The recent falls in ILG prices have changed the age profile proportions quite a bit, Peter.
At end June 2023 the total market value was £563bn (compared to £805bn three years ago), of which £95bn was less than 5 years to redemption, £195bn was 5-15 years, and only £273bn was over 15 years. The over 15 years three years ago had a market value of £540bn.
So slightly more than half of the issues by market value are 15 years or less to redemption.
Acknowledged – I was looking at the nominal and current redemption values reported by the DMO.
As the yield differential has not significantly widened over these three years, it looks as if this was all explained by the general rise in yields and not due to any relative attractiveness or otherwise of ILGs vs CGs, which is what determines the inflation assumption.
I do wonder however what the effect of the halving of the market value over the past 3 years of the over 15 year ILGs despite the recent inflation experience increasing their maturity values will have on the confidence of potential purchasers.
Peter you say that “ ILGs should not be of interest to the decumulation phase of money purchase arrangements and during the accumulation phase would be purely a speculative investment .
In decumulation phase this is often viewed as a single event I think this is a mistake. It is possible to construct a series of maturity dates with RPI linked outcomes.
The objective being to preserve the buying power of the inputs.
During the accumulation phase there are speculative opportunities, such as happened in September 2022 when there where clear opportunities. The 2034 ILG could be bought for less than its 2004 issue price.
I will do more work on the “dirty price” and the reinvestment of the modest coupon