Splitting inflation and nominal interest rates

During early 2012, one of our schemes was constrained by the funding basis and the availability of contributions from the employer to the extent that it could not afford to reduce the level of risk and purchase additional protection at the current market price.  In order to maximise protection we decided to amend the triggers and split the nominal interest and inflation rate parts of the implementation, using separate triggers for each part.  We worked with the client to increase the level of real interest rate hedging on the scheme’s liabilities. As a result the scheme:

• Undertook additional hedging of inflation during October 2012 when the cost of purchasing inflation fell due to the announcement from the ONS of consultation on the calculation of RPI;
• Undertook additional interest rate hedging during August 2013 on the back of rises in nominal interest rates following the tapering announcement from the Federal Reserve.

The result was that the scheme was able to hedge a portion of its inflation linked liabilities at an effective yield of 0.65% per annum.  The chart above shows the real yields available on index-linked gilts during the timeframe and shows that the effective yield achieved by the scheme was significantly above the yield available at any point in the market over the past 12 months.

This highlights that by designing the triggers in this manner we were able to hedge the liabilities at a rate around 10% cheaper than available at any point in the market over that period.  This has therefore provided a considerable benefit to both the trustees and employer. This strategy work seeded F&C’s new Dynamic Inflation Fund with the initial stage of hedging in August last year.