Specialist LGPS Investment Strategies | Insight Investment | Insight Investment

Inflation protection at the right price is a key way local government pension schemes can protect newly established surpluses.

In this video, we explore the scale of how inflation impacts upon pension payments and show how a price-sensitive approach to buying inflation protection can help.

To illustrate why inflation matters, here is an example of annual pension payments for a £1 billion fund. In dark green, we show the size of the payments if inflation is on target, while in light green, we show the impact of inflation overshooting by 1% per annum. You can see here the size of those cash flows rise dramatically.

Over the life of the fund, this overshoot costs an additional £800 million of payments, eroding the fund surplus and ultimately leading to higher contributions.

But is this type of risk realistic?

Over recent years, we see a pattern of periods of low inflation punctuated by bursts of high inflation.

So you may wish to protect against future periods where inflation is elevated, whether that is a period of stubbornly high inflation, such as after the global financial crisis in 2008, averaging 3.3%, or the spike of inflation over the past five years.

This compares to the cost of contractual inflation protection, meaning you can benefit from protection during these higher inflation periods.

We recognize that LGPS funds want value for money, which means only adding inflation protection at the right price.

This chart shows the cost of inflation protection over time.

We've highlighted the periods where cost is reduced.

In order to take advantage of these opportunities, you need to firstly be prepared and be ready to act quickly.

Secondly, have a partner with longstanding experience monitoring triggers daily and implementing a tailored solution when attractive levels are reached.

And finally, implement via assets offered direct contractual link to inflation experience.

If this is of interest, we'd be delighted to discuss with you further.

When interest rates were ultra low, the focus for LGPS Treasury teams was on protecting capital and ensuring access to liquidity.

So there was little benefit for making cash work harder.

Now that short-term interest rates are back to levels last seen before the global financial crisis, it is worth focusing on both liquidity and return objectives.

We think the opportunity is best viewed as a liquidity ladder made up of a range of liquidity and short-term bond fund options.

So where same-day access to funds is required, a short-term money market fund makes sense.

Such a fund should provide security of capital, liquidity, yield, and it should also have sufficient scale.

For slightly longer-term cash needs, where same-day access to funds is not required, an enhanced money market fund can provide investors with a modestly higher level of return without a deterioration in credit quality.

Investments here focus on taking credit exposure via a diversified portfolio of floating rate note bonds.

A modest allocation to high-quality asset-backed securities can also be used to enhance returns.

Lastly, for longer-term or strategic allocations to cash, investors can benefit from a range of funds that invest in very liquid, short-dated asset-backed securities.

These funds can benefit from a complexity premium that provides a return between 75 and 125 basis points above SONIA for AAA and AA-rated credit risk.

The creation of such a liquidity ladder can enable local government pension schemes to enhance their level of return that they receive with diversified exposure.

If you have more questions, we would, of course, be happy to talk to you about this.