Hedging inflation risk: a practical guide

By 5 minute read

Investors with a long horizon should carefully consider how to manage inflation risk. For example, in defined contribution (DC) schemes the impact of inflation on the purchasing power of participants’ pensions will be significant, even at relatively low inflation levels. We have investigated the relationship between inflation changes and the returns of several asset classes.

Over January 2019, Statistics Netherlands (CBS) has reported the highest inflation rate since September 2013. This highlights the risk of a sharply rising inflation and raises the question which financial instruments can mitigate inflation risk. Some instruments, such as inflation-linked bonds, provide a direct inflation hedge. The inflation protection of equities, real estate and infrastructure is, however, usually very limited in the short and medium term. Only commodities (especially gold) and unlisted real estate achieve a better score in this respect and thus provide a better inflation hedge.

Inflation risk for Dutch pension funds

Dutch pension funds typically use Dutch inflation as the basis for indexation of pensions. In the ideal situation this means that if these pension funds want to hedge inflation risk, they need to purchase instruments based on Dutch inflation. However, currently there are no liquid instruments with a direct link to Dutch inflation available. In contrast, governments of a number of other countries are issuing inflation-linked bonds. The three countries with the largest issues are the United States, the United Kingdom and Brazil. Within Europe, the United Kingdom, France and Italy are the three countries with the largest issues.

If Dutch pension funds choose to hedge (part of) the inflation risk with inflation-linked bonds, the relationship between Dutch inflation and the inflation of the country on which the price development of the inflation-linked bond is based is important. Correlation analyses show that there is a strong correlation between Dutch inflation and that of the Eurozone (the correlation is around seventy percent). Eurozone inflation is thus the best proxy for inflation for Dutch pension funds.

Characteristics of different asset classes

Table 1 shows how different asset classes score on several important characteristics. This involves looking at investment instruments that offer direct inflation protection as well as instruments that offer more indirect protection (in the long term). A plus (+) in the table means that an investment instrument is relatively attractive in terms of a certain type of risk. As a result, we can compare the different instruments. For example, equities have a very low liquidity risk (++) because they are more liquid than inflation-linked bonds (+).

Table 1: Overview of various asset classes with respect to a number of important characteristics. Source: Aegon Asset Management, TKP Investments.

Inflation protection of different asset classes

On the basis of quantitative analysis, the relationship between the development of unexpected inflation and the price development of several asset classes has been investigated. These results are shown in Table 2. Various subcategories of equities and fixed-income securities are considered, as well as real estate, commodities and a selection of currencies. The analysis includes both a correlation and regression analysis with both providing insight into the aforementioned relationship. This shows that in the shorter term very limited inflation protection is offered by the various asset classes considered. In recent years however, there has been a relatively low and stable inflation trend. If inflation unexpectedly increases sharply, this will affect the price development of financial instruments. That is why the specific characteristics of the instruments to protect against unexpected inflation should not be forgotten.

Table 2: Relationship between different asset classes and unexpected Dutch inflation (1-year horizon). Source: Aegon Asset Management / TKP Investments.

Impact on defined contribution schemes

The best protection against inflation is by achieving long-term positive real returns. Short-term shocks in inflation will then, in most cases, be absorbed. In the years before retirement – if the risk and hence the expected excess return is reduced – it may be desirable for some participants to reduce the volatility of their expected real pension by including inflation-linked bonds in the investment mix. However, the economic circumstances at the moment will be an important consideration.

Many Dutch pensioners with DC pensions will receive an annuity fixed in euro terms during their retirement. The resulting decline in the real pension over their retirement is not necessarily a problem for many participants but should definitely be considered. Because of a new act in The Netherlands (in Dutch, the "Wet Verbeterde Premieregeling") it is now possible to still invest after retirement. This offers an interesting solution for participants who wish to maintain the level of their pension in real terms during retirement, with the introduction of investment risk.

Sibrand Drijver

About Sibrand Drijver

Investment Solutions Consultant