26 Apr 2023 4 min read

LPI 101: between the cap and the floor

By John Southall

The complexities of hedging capped and floored pension scheme liabilities.


Most UK DB pension schemes have benefits linked to Limited Price Indexation (LPI), which means liabilities are indexed to either RPI or CPI, subject to a cap and a floor. We introduced this idea in part one of our blog series, and in this instalment we’ll examine why hedging these caps and floors is a complicated business.

The regulatory logic for LPI is that caps limit the cost of pensions to the corporate sponsor, while floors protect pensioners from their pensions’ values falling in nominal terms. LPI increases can come in many different flavours, reflecting changing regulatory requirements over time. LPI(0,5), that is RPI with a cap of 5% and a floor of 0% applying each year, often represents the largest portion of liabilities:


How can these LPI liabilities be hedged? An inflation-linked asset that is capped and floored would seem the ideal instrument. Such assets, in the form of LPI swaps, exist. However, the market for them is exceptionally illiquid.

Delta hedging

A common alternative solution to the challenge is to ‘delta hedge’ LPI liabilities. In this context, the ‘delta’ reflects how sensitive the LPI rate is to changes in the RPI rate.

To delta hedge LPI liabilities, the cashflows are ‘split’ into purely fixed and purely inflation-linked components (i.e. with no caps or floors) that have the same sensitivities to small movements in interest rates (PV01) and inflation (IE01) as the original LPI-linked liabilities.

The resulting fixed and real cashflows become the benchmark for the LDI portfolio and can be hedged using liquid nominal and inflation-linked instruments, removing the need to trade inflation options:


Static delta hedging

A pragmatic approach to delta hedging involves recalculating and rebalancing the hedge every year, or sooner if there is a particularly large move in expected inflation. As this typically involves many months without a change in the benchmark, this is sometimes referred to as ‘static’ hedging.

Unfortunately, LPI deltas tend to change over time due to a variety of factors, the primary one being changes in inflation expectations (or ‘gamma’ risk):


Since a traditional delta hedge reflects the inflation sensitivity of LPI cashflows, the hedge can degrade due to changing market conditions and other factors. In addition, there is typically a time lag between ‘splitting’ the cashflows and implementing the updated LDI benchmark due to the required governance, which can further exacerbate the mismatch.

Dynamic delta hedging

While a ‘static’ approach isn’t terrible, more precise hedging could become more important as schemes de-risk and their ‘primary’ risks (such as equity risk and interest rate risk) reduce.

‘Dynamic’ LPI hedging involves re-calculating the PV01 and IE01 of LPI cashflows on a frequent basis, such as daily. If the gap between these and the PV01 and IE01 of the assets exceeds a tolerance the strategy may be rebalanced at the next rebalancing opportunity, which might be monthly[1]. The key benefit of dynamic LPI hedging is that it captures changes in the inflation sensitivity of LPI cashflows more accurately, allowing assets to better match liabilities.

The chart below shows how managing an LDI portfolio to a ‘static’ LDI benchmark over the period March 2021 to February 2023 could have resulted in a ‘hidden’ inflation over-hedge, at times around 20% too large.


Dynamic LPI hedging could also have economic benefits. For example, delta-hedging LPI(0, 5) pensions often involves buying inflation-linked instruments when inflation expectations are low and selling inflation-linked instruments when inflation expectations are high, which can incrementally add value. Care is needed, though, and we will discuss this idea, and its pitfalls, in more detail in a future blog.  Stay tuned!


Important information

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[1] The setting of appropriate tolerances is an important consideration, which will be discussed in detail in part three of our blog series.


John Southall

Head of Solutions Research

John works on financial modelling, investment strategy development and thought leadership. He also gets involved in bespoke strategy work. John used to work as a pensions consultant before joining LGIM in 2011. He has a PhD in dynamical systems and is a qualified actuary.

John Southall