New analysis from Alpha Real Capital (Alpha), a specialist manager of secure income real assets, suggests that GBP450 billion of inflation‐linked liabilities belonging to UK defined benefit pension schemes remain unmatched.
Alpha observes that higher inflation risks currently prevail, which means demand for inflation-linked assets continues, yet there is a lack of supply of such assets.
The analysis from Alpha, which is detailed in a new paper entitled, “Will Inflation take off? How can this risk be managed?”, suggests the value of private sector UK defined benefit fund liabilities is around GBP2.2 trillion, of which approximately GBP1.5 trillion is inflation‐linked. There are only around GBP800 billion of index-linked gilts, which suggests a shortfall of GBP700 billion. However, as many schemes use Liability Driven Investment techniques, the portion of inflation‐linked liabilities is around 70 per cent or GBP1.05 trillion, which leaves around GBP450 billion of unmatched inflation-linked liabilities.
Alpha’s analysis also highlights that that there are not enough long dated index-linked gilts available to enable pension schemes to match their longer‐term liabilities.
Analysis of the current supply of index‐linked gilts reveals that out of 31, only 14 have a maturity of more than 20 years and only three of these have a maturity greater than 40 years, representing only approximately 14 per cent of the total market value of index‐linked gilts. The longest dated gilt – maturing in 2068 – was introduced in 2013. Alpha comments that with no extensions in maturity for nearly a decade and relatively low issuance at the long end, the duration of the index‐linked gilt portfolio has fallen.
Adding to heightened inflation fears, Alpha says schemes are moving closer to their endgame faster than expected. Funding levels have fared well, and in many cases, actually improved through the pandemic as a result of the strong performance of risk assets. This means that pension funds not only want to de‐risk but many more can afford to do so, which means demand for inflation-linked assets remains high. The certainty given by the recent RPI reform announcements on the future of the RPI measure is another factor catalysing some pent‐up demand for inflation‐linked assets.
Shajahan Alam, Director of CDI Alpha Real Capital, says: “Despite the high level of gilt issuance practically every year since the financial crisis – with a truly record breaking GBP486 billion raised in 2020/21 as the Government needed to finance the fight against the pandemic – there remains a shortfall of index‐linked gilts.
“While the absolute levels of index‐linked gilts issuance have been high at an average of around GBP30 billion a year since the financial crisis, the proportion of total issuance that is index‐linked has fallen dramatically from a high of 25 per cent to as low as 5 per cent more recently.
“So, while the Government’s financing needs are expected to remain elevated, the supply of index-linked gilts is unlikely to satisfy demand.”
Edward Palmer, CIO Alpha Real Capital says: “Our analysis comes at a time of growing concern amongst pension schemes about rising inflation. Our research suggests that over 70 per cent of UK pension schemes see a moderate or high risk that higher levels of inflation may persist in the longer term. Over half of the respondents also said they planned to increase their level of inflation hedging. They may find this increasingly difficult, and in this context alternative asset classes such as commercial ground rents may have an important role to play.”
Phillip Rose, CEO Alpha Real Capital says: “Commercial Ground Rents are one option for investors to utilise secure income from real assets to achieve strong inflation hedging with investment grade risk, while securing a significant yield pick-up over index-linked gilts.”
