LDI chart update: I CPI

CPI has been making waves of late. We attribute this to the combination of a number of factors:

• Residual risks are being discussed: Many mature pension funds are well-funded and considering their residual risks: CPI, LPI, longevity, etc.
• Market pricing is interesting: Our sense is that the RPI CPI differential, or ‘wedge’ (pre-2030) is wider than many actuarial estimates (market pricing is in the region of 0.9% to 1% but some actuarial estimates may be lower than this). This means that hedging could potentially ‘lock in’ a benefit versus actuarial liabilities
• RPI reform is getting closer: RPI will be reformed to use CPIH[1] methodology and sources in a little over five years (February 2030)
• Future CPI supply: The recent announcement of auction results for renewable allocation rounds[2] and the potential future supply of CPI (as the government guarantees a minimum payment that increases with CPI)

Residual risks

Pension fund liabilities are a complex beast with different inflation linkages, caps and floors. CPI linkage generally plays some part in this mix but to differing extents, depending on the pension fund in question.

Those schemes with a large amount of CPI linkage in their liabilities (schemes that are likely also seeking to run lower-risk portfolios generally) will often consider their hedging strategy in more detail.

Pre-2030 (assets linked to RPI and RPI methodology see no change)

The RPI CPI ‘wedge’ has a long-term average (since 1996 to date) of c.0.95%, albeit this consists of long periods below or above this level and therefore pension fund actuaries will use a range of assumptions.

Current pricing out to 2030 is around 0.9% to 1% i.e. comparable to what has historically been realised. For most schemes this is likely to be the main focus.

Post-2030 (assets linked to RPI and RPI methodology will look like CPIH)

In this case the ‘wedge’ to consider is CPIH CPI. Historically this has (understandably) been broadly ignored. We would tend to agree that there is a weaker case for hedging the CPIH CPI basis because of the lower volatility and relatively high cost/increase in illiquidity/complexity to remove a small risk.

Nonetheless it is at least worth being aware of this basis and understanding the dynamics involved. The chart at the start of this blog shows a long-term history of the basis back to 1996. Supporting this start date is the era of inflation targeting in the UK and the fact that as the ONS notes “the official CPI series started in 1996”.

The average over this period is 0 but there have been periods where CPIH has diverged from CPI, most notably in 2022 in fact – during this recent period of high inflation OOH (owner occupied housing) was lower than CPI which was impacted more at that time by high energy prices.

We hope this provides a helpful refresher for those who are considering residual risks within their DB pension fund.

As a reminder our clients and their advisers can access their collateral sufficiency metrics (and more) on a daily basis on our online portal, LGIM Connect.

Additionally, for monthly commentary on the latest moves in LDI markets, please see our recently refreshed Solutions Monthly Wrap.  

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[1] Consumer Prices Index including owner occupiers' housing costs (CPIH). The ONS states: “The CPIH is the most comprehensive measure of inflation. It extends the Consumer Prices Index (CPI) to include a measure of the costs associated with owning, maintaining and living in one's own home, known as owner occupiers' housing costs (OOH), along with Council Tax. Both are substantial expenses for many households and are not included in the CPI. The OOH component accounts for approximately 16% of the CPIH.”

[2] Contracts for Difference Allocation Round 6 results (publishing.service.gov.uk)