Inflation increases with caps and floors - managing LPI-linked cashflows
DB pension schemes typically pay inflation-linked benefits with caps and floors, called limited price indexation (LPI) linked benefits. How should trustees manage these cashflows?
LPI benefits present a risk management challenge to pension schemes. The ideal hedging instruments are LPI swaps. But the UK LPI swap market has become increasingly illiquid
While inflation increases in pension scheme benefits often reference the retail price index (RPI), typically the increases come with caps and floors, e.g. benefit payments increase in line with RPI with an upper limit of 5% and a lower limit of 0%. These limited price indexation (LPI) linked benefits do not have exactly the same sensitivity to moves in interest rates and inflation as pure RPI-linked benefits. As such, they create a challenge for schemes looking to hedge their liability risk.
Given the scarcity and prohibitive cost of LPI-linked instruments many pension schemes adopt a pragmatic approach buying a mix of fixed and RPI-linked assets so that their combination has the same sensitivity to moves in inflation as the LPI-linked liabilities. We believe that this approach, known as ‘delta hedging’, is sensible but the risks involved are often hidden and neglected. In this article we detail:
- How using market prices of LPI swaps to determine the delta hedge (i.e. the mix of fixed and RPI-linked assets) is problematic because the LPI swap market implies unrealistic inflation behaviour.
- No single correct real-world alternative method exists. We illustrate one approach that we believe is likely to reduce long-term risk relative to using market pricing. However a degree of risk remains in practice – we call this ‘LPI risk’ and find that it is a significant unappreciated risk in many schemes.
- LPI risk becomes more important as schemes derisk. Understanding LPI risk and other ‘small’ risks encourages a practical approach when rebalancing and has implications for wider investment strategy.
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