UK DB pension schemes have £450bn of unmatched inflation-linked liabilities

UK defined benefit (DB) pension schemes have £450bn of inflation-linked liabilities that are unmatched due to a shortage of long-dated index-linked gilts, analysis by Alpha Real Capital has estimated.

As reported by our sister title, Pensions Age, according to the analysis, private sector DB schemes' liabilities total around £2.2trn, of which approximately £1.5trn is linked to inflation.

There are around £800bn of index-linked gilts, suggesting that there is a shortfall of £700bn.

However, due to many schemes using liability-driven investment (LDI) techniques, the portion of inflation-linked liabilities is around 70 per cent, leaving a shortfall of approximately £450bn.

Alpha Real Capital noted that although the absolute index-linked gilts have averaged around £30bn a year since the financial crisis, the proportion of total issuance that is index-linked has fallen from a high of 25 per cent to as low as 5 per cent more recently.

The firm’s research found a growing concern amongst pension schemes about rising inflation, with over 70 per cent of schemes seeing a moderate or high risk that higher levels of inflation may persist in the longer term.

Over half of those surveyed stated that they planned to increase their level of inflation hedging.

Alpha Real Capital warned that the issue could get worse because, in addition to heightened inflation fears, schemes were moving closer to their endgames faster than expected.

As funding levels have fared well through the pandemic, increased numbers of pension schemes want to de-risk, resulting in demand for inflation-linked assets to remain high.

Furthermore, the certainty given by the recent RPI reform announcements is catalysing some pent-up demand for inflation-linked assets.

“Despite the high level of gilt issuance practically every year since the financial crisis – with a truly record breaking £486bn raised in 2020/21 as the government needed to finance the fight against the pandemic ‐ there remains a shortfall of index‐linked gilts,” said Alpha Real Capital CIO, Edward Palmer.

“While the absolute levels of index‐linked gilts issuance have been high at an average of around £30bn 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.”

Alpha Real Capital’s research highlighted there were not enough long-dated index-linked gilts available to enable pension schemes to match their longer‐term liabilities.

Its analysis of the current supply of index‐linked gilts reveals that out of 31, 14 have a maturity of more than 20 years and only three of these have a maturity greater than 40 years, representing approximately 14 per cent of the total market value of index‐linked gilts.

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