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The Actuary The magazine of the Institute & Faculty of Actuaries

Inflation hedging by UK pension schemes hits record high

The use of inflation hedging reached a record high of £13.9bn in the first quarter of 2012 as UK pension schemes tried to protect against the risk of future high inflation, F&C Investments said yesterday.


The asset management company’s latest Liability Driven Instrument Survey shows inflation hedging in the first three months of the year was nearly double the amount that took place during the same period in 2011. F&C said the increased use of the approach, which involves investing in an asset that is expected to increase in value in line with inflation, reflected the uncertain investment outlook affecting pension funds.

It also highlighted attractive market levels for inflation hedging. The average retail price index swap rate in the first three months of this year was 3.5%, compared to 3.7% in quarter four of 2011. For a typical pension scheme this could translate to a 4% reduction in liabilities, and F&C said some schemes had managed to reduce the implied liability value by a further 4% by buying inflation-linked gilts and selling away the interest rate hedge via swaps.

Its analysis of the volume of hedging transactions by investment banks found interest rate hedging – which attempts to mitigate against the risk of interest rate changes – fell from the equivalent of £14bn of liabilities in Q4 of 2011 to £13.3bn in the first quarter of 2012.

Alex Soulsby, head of derivative management at F&C, said: ‘Unconventional and untested policies like quantitative easing are causing pension schemes to focus on protecting against the risk of future high inflation. Although current inflation remains high, prices for long-term inflation hedges are attractive.’

Economic uncertainty was also making it harder for schemes to decide whether to hedge with bonds or swap, he said. ‘As Europe edges closer to the precipice with further downgrades in Spain, the UK’s AAA rating remains, therefore gilts will retain their safe haven status for now.

‘However, internal risks are increasing as data now shows the UK to have been in a technical recession since Q4 2011. This uncertainty makes the consideration of whether to hedge with bonds or swaps all the more difficult for trustees.’

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