Linking Pension Liabilities to Assets

@Ajfinance, my assumption here is that liabilities are not inflation indexed. If they are, e.g. wages are inflation-indexed, then RRB would be a good hedge. But yes, some pension funds do offer that inflation-indexing of future benefits.

@AJFinance your point 2 nails it (I think). All bonds will always offer protection against ‘expected’ inflation – not necessarily in their rate of return, but their pricing. Bond pricing is heavily dependent on risk free rate, of which inflation will be a necessary factor. In fact, any financial instrument or investment will incorporate a current view of inflation expectations – otherwise it’s not a good instrument!

However, you’re right about point 2 – it’s unforeseen changes in inflation that a Real Return Bond hedges against. A nominal bond only looks at rates/coupons on a nominal level (e.g. fixed rate, LIBOR, etc). A Real Return Bond would have payouts fixed to an actual inflation index (i.e. an index that reacts to changes in inflation levels).

In my view, not every bond is distinctly a nominal or real return bond. LIBOR etc inherently incorporates a bit of inflation, and inflation indices aren’t perfect.

I agree the issue does get a bit confusing once you talk about pension accounting and wages. I welcome more details and a further discussion if you like! 😀

If there’s a particular question let me know @AjFinance. Works better through application. I need to make sure I’m right as well in my explanation, been rusty!

Ok, having a go at this.

First, I must admit I’m not sure what this statement really means…

When trying to fund future pension obligations, the wage increases that might be attributable to inflation are hedged with Real Return Bonds. Also, the wage increases that are not really related to inflation can be hedged with Nominal Return Bonds.

But nevertheless, it shouldn’t affect both the statements.

1. Now I realise that Real Return Bonds include debt instruments like TIPS which explicitly offer inflation protection, they are designed to hedge that risk. But won’t a nominal return bond do the same thing as they include an inflation component?

Nominal return bonds includes an expected inflation component. So you won’t know your real yield on a nominal bond until maturity, where you know the actual inflation over that period. That is the source of inflation risk and uncertainty. With Real Return Bonds (RRB), you have perfect hedge of inflation, as the essence of RRB is that the real yield is guaranteed (vs. nominal bonds where nominal yield is guaranteed).

How does this work? RRB differ in 2 ways generally, first the principle accrues with inflation throughout the life of the bond, and secondly the coupon is based on a (generally lower) real rate of return. Hence, the real-return-based coupon payment is applied on the inflation-accrued principle – thus both principle and couple are hedged from inflation. This is not the same for nominal return bonds where unexpected deviations of inflation are not accounted for. Therefore you’d expect the nominal yield to be higher due to inflation risk premium as well.

2. Real Return Bonds offer protection against “unexpected” inflation as well. Whereas, Nominal Return Bonds incorporate only the “expected” inflation assumption in their rate of return.

You arrive at similar conclusions here.

Is it due to this fact that Real Return Bonds are a preferred source for hedging liabilities, assumed to be influenced by inflation?

But it’s not due to RRB being a preferred source for hedging liabilities. You choose a hedging instrument suitable to (ideally perfectly) offset the risk of your liabilities. Asset/liability mismatch occur when assets and liabilities are exposed to different risk factors OR are affected to different degree through the same risk factors. So no hard and fast rule here. Plus if the goal is to minimise pension funding shortfall, the asset risk should mimic liabilities, I would have thought. Investing in RRB when liabilities are affected by inflation increases the mismatch?

I hope this makes more sense? Happy to discuss

@ajfinance if you have a particular question just shoot it here 🙂