Expert panel: Inflation risk — to hedge or not to hedge?

What is inflation risk?

For a plan that provides inflation-linked benefits, inflation risk is the risk the plan experiences losses due to future inflation. This occurs when future inflation increases the plan’s liabilities faster than it increases the plan’s assets.

Canadian inflation has been low and stable for many decades, leading some DB plan sponsors to mismatch their inflation-linked assets and liabilities. In some cases, plan sponsors assumed a fixed rate of inflation or relied on return-seeking assets to pay for inflation-linked benefit increases. This strategy works if inflation remains low and stable, but can lead to losses if inflation is high.

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The first step to understanding inflation risk is to quantify how different levels of future inflation impact a pension plan’s assets and liabilities.

Once this is done, the plan sponsor can decide whether the potential financial impacts are acceptable. It’s helpful to consider the impact of inflation on the plan sponsor’s core business as part of this analysis. For example, if inflation is bad for the plan sponsor’s core business then reducing inflation risk in the pension plan becomes more important.

Plan sponsors that wish to decrease their inflation risk have two different options: better aligning inflation-linked assets and liabilities and purchasing inflation-linked annuities. (In the interest of full disclosure, Sun Life provides both investment and annuity solutions.)

Better aligning assets and liabilities

One way to reduce inflation risk is to better align inflation-linked assets with inflation-linked liabilities. For most DB plan sponsors, this means adding inflation-linked assets to their portfolios.

Traditionally, real return bonds have been the gold standard for hedging inflation. In Canada, 89 per cent of outstanding real return bonds are issued by the federal government, with the rest coming mainly from Manitoba, Ontario and Quebec and a few non-government issuers, according to FTSE Canada’s real return bond index as of Oct. 31, 2021. This limited issuance of real return bonds with a credit spread makes it challenging for plan sponsors to hedge inflation risk without sacrificing yield.

Read: Expert panel: How could inflation impact DB pension plans?

Some investment managers have developed creative solutions to address this challenge. Those with experience in repurchase agreements or derivatives markets can synthetically add credit spread to federal real return bonds, either by overlaying the credit spread of a nominal provincial bond using a long/short strategy or a U.S. corporate bond using credit default swaps.

Other asset classes such as real estate or infrastructure typically derive some benefit from cash flows that increase with inflation as well — whether it be rent prices or bridge tolls. As a result, these asset classes may provide partial inflation hedging over longer periods.

Transferring risk

A second way to reduce inflation risk is to purchase inflation-linked group annuities. This allows DB plan sponsors to transfer the investment, longevity and inflation risk for a group of plan members to an insurance company.

Inflation-linked annuities have been available in Canada since 2013. Over time, new solutions were created and market pricing has improved. In fact, the improvement in pricing was reflected in the Canadian Institute of Actuaries’ annuity purchase proxy in mid-2020.

Read: Actuaries respond to Ontario’s proposed funding rules for DB plans

Recent inflation concerns and the evolution of the market have resulted in renewed interest in inflation-linked annuities. Over the last year, Sun Life estimates that 11 inflation-linked annuities have been purchased by DB plan sponsors covering about $700 million of liabilities. This is a substantial increase compared to the preceding year.

Here are a few considerations for plan sponsors that are interested in purchasing inflation-linked annuities:

Inflation formula: Most plan sponsors choose to purchase annuity buyouts or buy-ins that mirror the inflation-linked formula of their pension plan. This provides a full transfer of inflation risk.

Occasionally, plan sponsors choose to purchase annuity buy-ins with inflation-linked formulas that are simpler than the inflation-linked formulas of their pension plans. This can result in a better price if the plan sponsor’s formula is very complicated. However, it’s important to note that the plan sponsor retains the inflation basis risk between their actual formula and the annuity formula.

In-kind transfer: Being able to transfer a portfolio of inflation-linked assets as part of the purchase can improve annuity pricing for the plan sponsor. An in-kind transfer decreases the friction costs of buying/selling assets and allows the insurance company to hold smaller risk margins for the transaction.

Read: Two decades of low inflation push DB pensions toward alternative investments: Bank of Canada

Transaction size: The Canadian market has seen numerous larger inflation-linked deals over the years. Sun Life estimates that the market can absorb a single day inflation-linked deal in excess of $500 million.

The coronavirus pandemic has created a lot of uncertainty around future levels of inflation. Now is a great time for DB plan sponsors to quantify their inflation risk and re-assess their risk tolerance. Consultants, insurance companies and investment managers can all play a part in this journey.