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Match made in Heaven?

This summer has seen the Greater London Authority (GLA) issue a ground-breaking bond to aid its funding for infrastructure projects. This market leading bond issuance was not heralded either for the amount of money raised or for the bond’s duration. Instead, this bond is a first in the Sterling bond market to be linked to the Consumer Prices Index (CPI). Up until June 2015, all other index-linked bonds were linked to the Retail Prices Index (RPI), despite CPI being the Government’s main measure of inflation. In the short time since the GLA CPI-linked bond issuance, further CPI-linked bonds have been issued, including one for £100m by the Church of England.

Since legislative changes linked statutory increases to CPI rather than RPI, pension schemes now have a significant amount of liabilities linked to CPI. Whilst the value of pension scheme liabilities has decreased as a result of this change of inflation indices, the lack of CPI-linked bonds in the market has impacted on the treatment of the liabilities.

With the Pensions Regulator placing much emphasis on the removal of risk from investment strategies, investment consultants have been advocating Liability Driven Investment (LDI). A LDI strategy simply looks to match assets with liabilities. This is appealing to pension schemes that are fully funded on a valuation basis, as if the scheme’s assets can match the movement in the scheme’s liabilities then, in theory, the pension scheme will remain fully funded on that basis. There will never be a 100% match between the assets and liabilities, primarily due to mortality risk, however the lack of CPI-linked bonds served to highlight this within a LDI strategy.

Another issue has been the actuarial derivation of a CPI inflation assumption given the lack of CPI-linked bonds. The typical approach had been to derive a RPI inflation assumption and deduct an amount to account for CPI being historically lower than RPI. The level of deduction applied will reflect the level of prudence required. The future difference between RPI and CPI is difficult to predict and is open to the Scheme Actuary’s interpretation of historic data.

A CPI-linked bond market will help alleviate both of the issues outlined above. However, this is a market that will take time to develop and this will not happen over-night. Additionally, the potential emergence of the CPI-linked bond market should not be viewed as a deterioration of the RPI-linked bond market. The importance is that the GLA bond issuance was a monumental step in creating this new bond market and has opened the door for others to follow suit. Should the Government decide to issue CPI-linked gilts then the market place would undoubtedly grow with insurance companies and pension schemes likely to lead the way in purchasing such gilts.

The UK Statistics Authority is currently undertaking a public consultation in relation to its publication of Paul Johnson’s review of the UK’s inflation statistics on 8 January 2015. Johnson made several recommendations within his report, which included a variant of CPI (CPIH) being used as the UK’s main measure of inflation and a declaration that RPI is “not fit for purpose and should not be used except where existing legal contracts – for example index-linked gilts – demand it”.

The report favours the eventual discontinuation of the RPI. The consultation closes on 15 September 2015 with the summary of responses being published on the UK Statistics Authority website during autumn 2015.


Ryan Parsons – Consultant