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What do inflation hedging and scuba diving have in common?

Investment insights: Inflation hedging vs scuba diving

KPMG’s Anna McMullan provides a comparison of common themes across liability driven investment (LDI) and scuba diving, alongside key considerations for pension scheme risk management.

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Patrick Race

Partner, Investment Advisory

KPMG in the UK

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I obtained a scuba diving qualification under a well-known scuba-diving body, and with this I thought the sea was my oyster. I soon found out that while this qualification was highly respected by some, it was seen as a “holiday-diver’s” permit by others who had learned to dive under a different diving body. Despite the fact that I am a holiday diver, these were harsh words after all that time spent wrestling to get wetsuit boots on and off, a labour intensive job not for the fainthearted.

Out of all the risks you face when deep-sea diving, inflation, luckily, isn’t one of them. So what does all of this have to do with pension schemes and inflation hedging? Let me explain.

The actions taken when deciding to learn how to scuba dive are not dissimilar to those a pension scheme trustee takes when hedging inflation. You seek advice from experienced professionals; be that a diving seasonaire or your investment consultant. You invest in impressive kit; be that a snazzy dive watch or complex inflation models. You assess the risks you are facing; do you want to scuba dive through a shipwreck in shark infested waters?

In the pension scheme world this may equate to 'are you running significant inflation risk without appropriate hedging in place?' You then take appropriate steps to mitigate these risks. After all of this, you probably believe you have mitigated the mitigatable, but this is actually where it gets complicated…

Every single diver is impacted differently by variables such as, what do you weigh? How much air do you consume? Are you likely to panic underwater? How deep are you going to go? So you can’t just throw a couple of weights around your middle, jump in and hope for the best.

Similarly, interest rates and inflation affect pension scheme liabilities in different ways, in that liabilities don’t move directly in line with published financial statistics, and are impacted by issues such as; what do the Scheme rules say about pension increases?

Are pension increases capped or floored? Do we know with enough accuracy when benefits are due? Are different types of members treated differently? What inflation model is the actuary using? Is regulation going to change? And so on… So you can’t simply buy a few index-linked gilts and say “we’re matched”.

In order to tackle the key inflation dilemma, pension schemes can adopt smart inflation hedging techniques, but they are all ultimately reliant on the Scheme Actuary’s chosen model and assumptions. This presents problems - there are lots of different models, and lots of different ways to set assumptions and the choice could have a very significant impact on the amount of inflation linked assets you buy in order to hedge your liabilities.

It’s possible that under one model you may be over/under hedging the “true” value of your liabilities, while under another your liabilities are perfectly hedged. This links back to how different dive school graduates assessed my skills and therefore the risk I was running while diving – it’s all because of the different bodies we qualified under and the assumptions and priorities that this brings.

In both cases, the evidence is inconclusive as to which model/body is the best one, unfortunately there doesn’t seem to be a “one size fits all” solution, and to the untrained eye it can be difficult to differentiate between the options.

So what does this mean? It depends. If you are like most people, a “holiday diver”, then the course you choose is probably much-of-a-muchness, but if you’re really serious about that dive through a shipwreck in shark infested waters, then you probably do want to look at the most appropriate body.

Likewise, the vast majority of schemes will be facing far bigger challenges with the level of investment risk, longevity risk, or covenant risk they are taking and these risks should be addressed before worrying about the precision of the method of calculating the risks. If a scheme has a strong funding position and most key investment risks broadly mitigated, then perhaps it is time to implement or fine tune an LDI solution.

In a nutshell, industry inconsistency may or may not be a huge issue for your scheme, but you’ll need to exercise care and a collaborative approach between actuary and investment consultant is more important than ever.

Whether you are diving or hedging inflation, a pragmatic approach should be taken that suits the specific situation, and in both cases something simple may be just right. If you would like to know more on any of the content covered, (including wetsuit boot removal tactics), please feel free to contact me with questions.

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