Articles - That’s not the shape of my curve

 By Alex White, Managing Director, Co-Head of ALM at Redington
 
 What’s the issue?
 DB pension fund liabilities are complicated, and they have caps and floors on inflationary uplifts (limited price inflation, or LPI). For pensions in payment, these are annual caps and floors. Because of this, payment profiles are simplified to a set of fixed and real cashflows to capture the same sensitivity (and we recommend refreshing the benchmark every time there is a large move in inflation, to make sure it still tracks).

 So far so good. What does this have to do with curves?
 Well, inflation curves aren’t dug out of the ground; they’re tools, and tools can be used for different purposes. Some curves are built to price every gilt linker precisely, while others are designed for liability pricing and simulations, where avoiding kinks in the curve can be more important. Perhaps the easiest example is in nominal gilts, where the longest-dated gilts (with over 40-year maturities) make up less than 5% of the notional outstanding, but offer tax advantages due to the low coupons, as well as capital efficient hedging (you get a lot of PV01 per pound invested, reducing the need for leverage).

 That makes them expensive. This issue has been getting larger, which means if you have a curve which prices each gilt precisely, you probably now have negative forward rates at the long end. To avoid this, you may need to accept being 1-2% off the pricing of those gilts.

 Clearly this trade off depends on what you’re doing. If you’re buying the things, you need precise pricing. If you’re calculating liability VaR, you don’t, but you do need a sensible curve and correlation structure.

 Back to benchmarks. If you’re making a benchmark, an overly jagged curve may not be suitable. If you have LPI0-5 linkage in liability payments (increasing at RPI, capped at 5% and floored at 0%), then forward rates of 0% and 8% will give a different price than forward rates of 4% and 4%. This is an extreme example, but the impact is there, and in the last year or so has become more and more pronounced; it can make a material (c5%) difference in overall inflation sensitivity.

 Now, this is hardly the only nuance in LDI benchmark construction. My favourite is probably the distinction between tenor point, cashflow, and pre-post sensitivity (hinting at the sequel here). The issue is, these “in the weeds” details can make a difference to what assets schemes buy, and therefore how they fare, and could be increasingly important in a world where surplus sharing is common and the investment outcomes of well-funded schemes become a driver of corporate earnings.

 
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