Good Governance for Pension Schemes by Paul Thornton & Donald Fleming

Author:Paul Thornton & Donald Fleming
Language: eng
Format: epub
Publisher: Cambridge University Press
Published: 2011-03-07T05:00:00+00:00

Price inflation

The assumption for future price inflation directly affects the future benefits that are to be valued, as most of those are now linked directly, or indirectly, to the RPI. However, the assumption may not, in practice, have that much impact on the overall valuation result, as the discount rate used to discount those future benefits may itself be linked to the expectations for future price inflation. Nevertheless, most valuations will make an assumption for price inflation.

The starting point for this assumption will be the gilt markets and, in particular, the difference between the fixed-interest gilt yields and the index-linked gilt yields – with the latter giving RPI-linked returns, this difference is an indication of the market assessment of future RPI. As gilt yields can vary by duration, it will be important to look at yields at a duration that is appropriate to the liabilities being valued. In the extreme, a different assumption can be used for the benefit payments due in each future year to reflect this. These duration-dependent rates can be obtained from yield curves available from the Bank of England and other sources.

There is a practice of making a small adjustment to the implied RPI rate, or rates, to allow for an ‘inflation risk premium’. The rationale for this is that investors will want a margin from their expected rate of RPI to reflect future uncertainties. In theory, this premium could be positive or negative, but a positive adjustment would be unusual. Where an inflation risk premium is applied, it should be consistent with the minimum risk discount rates – see below. The risk-free value of an RPI-linked benefit is obtained by discounting the current benefit amount at the index-linked yield. Increasing the benefit by an RPI assumption that is less than the difference between the fixed and index-linked yield and then discounting that increased benefit by the fixed yield will produce a lower value. This would be an underestimate of the risk-free value.

The inflation risk premium should therefore properly be considered in the context of the discount rate and the allowance for investment risk. If there is a mismatch between the split of the liabilities between real and fixed liabilities and the split of the assets between real and fixed assets, then considering whether there is an inflation risk premium may be appropriate.

Download

Copyright Disclaimer:
This site does not store any files on its server. We only index and link to content provided by other sites. Please contact the content providers to delete copyright contents if any and email us, we'll remove relevant links or contents immediately.