19th Annual Colloquium of Superannuation Researchers July 2011 The University of New South Wales Centre for Pensions

and Superannuation

The Role of Inflation-linked Bonds in a Post Retirement Solution

Tracey McNaughton, CFA1 Investment Specialist Fixed Interest, Credit and Cash

Colonial First State Global Asset Management

With thanks to Aaron Minney for his help and contributions to this paper.

Abstract

This year marks the first year in which the oldest of the baby boomer generation reaches 65, retirement age. Three million baby boomers are expected to retire in the next 20 years. The funds management industry is standing on the precipice of change that will see post-retirement savings swell to over $500 billion in just 5 years time and over one trillion dollars in 25 years time. With this change comes responsibility for managing the evolving risks of a post-retirement portfolio. Inflation risk is one such risk that is heightened in retirement because the natural hedge provided by the inflationadjusted wage earned from paid employment is no longer there. Despite this, few post-retirement products in Australia adequately provide protection against inflation. The effectiveness of different inflation hedging instruments is often researched and reviewed. Inflation-linked bonds are, however, the best hedge because they are the only asset class that directly references inflation.

Introduction The superannuation industry in Australia is on the precipice of change. Until now, much of the focus of research, design and reform has been on the accumulation side of the industry. Slowly, but surely, this focus is shifting driven by ageing memberships, longer life expectancies, growing balances and a wider variety of solutions now available. In the absence of any real alternative, superannuation members are choosing to exit their funds at retirement and take a lump sum payout. Superannuation funds in response are moving more and more to address the needs of their older members. Of the 65 industry funds in Australia, no fewer than 80% have indicated they expect to have some kind of retirement solution in place within the next three years . The funds that are the most advanced in considering more complex post-retirement products are typically those with older average memberships. Despite this growing awareness of post-retirement issues, few superannuation funds in Australia adequately address potentially one of the most debilitating risks a retired investor could face, that of inflation. The Risks in Retirement All investors will face three main risks when they enter the retirement phase of their investment lifecycle. These risks are market risk, inflation risk and longevity risk. Each of these risks should be given due consideration in a post-retirement investment strategy.
2

Market risk Market risk is the risk that the value of an investment will decline in value due to a change in value of the market in which the investment is made. If nothing else, the experience of the past few years has taught us how significant a role market risk can play in the financial fortunes of investors. The 50% fall in the stockmarket during the GFC, for example, would have wiped out 35% of the retirement savings of someone in a 70/30 growth-defensive portfolio. Negative returns do happen, sometimes spectacularly so. Since 1980, the Australian share market has gone down in one out of every four 12month period. The average fall in a down year was 13.4% . Just as important, however, is the timing of these negative returns in relation to an investors retirement age. An investor with a 15 year investment horizon and a portfolio made up of 70% Australian shares and 30% Australian bonds would have earned $427,700 in 2005 having begun their investment with $100,000 in 1990. The same investor starting just 5 years later would have earned $54,000 less. Such an outcome would mean less to an investor aged 40 years of age than to an investor aged 60 and about to retire. For the latter, the ability to recoup the lost returns is significantly hampered by no longer being in paid employment.
3

2 3

Based on a participant survey conducted at the Australian Super Investment Conference in 2010 Based on ASX200 monthly data dating back to 1980

Market risk of this type is most commonly managed by phasing down the riskiest part of an investors portfolio as they age .
4

Inflation risk Inflation risk is the risk of loss of purchasing power due to the increase in costs over time due to rising prices. For any investor, inflation risk can be hedged by earning an income that keeps up with the pace of inflation. This is somewhat easier to achieve for investors who are part of the paid workforce. For investors no longer part of the workforce, the ability to hedge out inflation is more challenging.

Longevity risk Longevity risk is the risk of outliving ones accumulated savings. This risk is directly correlated with rising life expectancies. Australias Future Tax System (2009) noted that Australians have one of the longest life expectancies in the world. We are living longer yet, until recently at least, retiring earlier. This necessarily implies either a greater amount of accumulated savings is needed in the preretirement phase of the investment lifecycle, or retirement ages must rise.

At present, the only commercial source of guaranteed longevity protection, apart from the Aged Pension, is through annuities issued by insurance companies. The problem is, these products are complex, expensive, and tax disadvantaged . As Sherris and Wills (2007) note, longevity risk is one of the remaining frontiers challenging modern financial markets and financial engineering.
5

Of these three risks confronting retired investors, the one most commonly considered and indeed easiest to manage is market risk. It is worth noting, however, that reducing market risk by raising the allocation to defensive assets, actually increases longevity risk for a post-retired investor. Apart from longevity bonds, which are yet to be fully embraced by either issuers or investors, there is no market based, liquid instrument available to manage longevity risk. Inflation risk, on the other hand, can be managed with instruments readily available. Unfortunately, it is a risk that quite often is poorly managed or not managed at all in post-retirement portfolios. The Cooper Review The recently completed review into the superannuation system in Australia highlighted the need for trustees to consider inflation and longevity risks when deciding on investment strategy for members. Trustees must devise a separate investment strategy for post-retirement members in MySuper

products which has regard to the factors as set out in section 52(2)(f) of the SIS Act as well as inflation and longevity risk. (Recommendation 7.4)

The arguments behind this idea were best espoused by Bodie, Z., R.C. Merton, and W.F. Samuelson, in Labor Supply Flexibility and Portfolio Choice in a Life Cycle Model. Journal of Economic Dynamics and Control Vol. 16, 1992, pp. 427-449. 5 Deferred annuities for example, are currently penalised under both tax and the age pension means test provisions during the deferment period.

In its Stronger Super response released in December 2010, the government supported this recommendation.

Previous studies of superannuation member attitudes towards the various risks around their superannuation accounts have found the risk of not being protected against the higher cost of living ranks higher than the risk of outliving savings. A study conducted in 2009 showed retirees risk tolerance became more conservative since first retiring because of concerns about the economy (68% or respondents) and concerns about the future effect of inflation (53%). The next most important reason to become more conservative was followed advice received from my personal financial adviser (25%).
7 6

Another 2009 report, produced by the Society of Actuaries , found that 58% of retirees and 71% of post-retirees expressed concern that the value of their savings and investments might not keep pace with inflation. Just 46% of retirees and 58% of pre-retirees said they were concerned they might delete all of their savings. Market risk and inflation risk were listed as the biggest concerns of all the risks listed by retirees and pre-retirees.

So whilst the Cooper Review recommends trustees to consider both inflation and longevity risk, it would seem inflation risk sits higher in the list on concerns for superannuation members than outliving their savings. Research is, however, still developing in this area. Moreover, as already noted, there are more readily available market based instruments present to address inflation risk than there are to address the issue of longevity risk. The need for inflation hedging Inflation has always been a concern for investors. Any investment requires some compensation for the real value that is lost through the increase in prices over time. The longer is the time horizon of the investment, the greater is the need to be concerned about inflation. The time horizon of retirement income products is long making the risk from inflation significant.

Inflation does not need to be high for it to be a problem. For example, consider a person who retires in 1980, by historical standards considered to be a relatively benign period of inflation. A basket of goods and services purchased for $100 in 1980 would cost that same retiree $365 in 2010, 30 years later. Over this period, inflation averaged 4.4%, just 1.1pp higher than where CPI is today. With no other means of income, this retiree must fund this increased cost from their accumulated savings.

An alternative way of thinking about this is to consider what additional return on their savings a retiree would need in order to compensate them for this increased cost of living. In the above example, the retiree would need to earn an additional 4.4% on their savings in order to offset the effect of inflation.

6 7

Will retirement assets last a lifetime?, Society of Actuaries, LIMRA, and InFRE, 2009. 2009 Risks and Process of Retirement Survey Report of Findings, Society of Actuaries, 2009.

Source: Colonial First State Global Asset Management; based on portfolio invested 70%/30% in Australian shares and Australian bonds.

The chart above expresses this in terms of real and nominal returns on a balanced fund. To effectively offset the higher cost of living between Dec-89 and Dec-10, a retiree would need to earn an additional 2.9% compound annual growth rate. The Federal Government recognises this need to protect retirees against inflation. The Governments Aged Pension is indexed to meet increases in the cost of living using the Consumer Price Index, the Aged Pensioner Household Index (APHI) constructed by the ABS, or Male Total Average Weekly Earnings (MTAWE), whichever is the greater. The APHI is specifically designed to reflect the price of a basket of goods and services that a typical retiree would purchase. As can be seen from the chart below, the correlation between the CPI and the Aged Pensioner Index is high but there have been periods of divergence, mainly due to food price inflation.

Source: ABS 6463.0 - Analytical Living Cost Indexes for Selected Australian Household Types, Dec 2010 Hedging inflation risks The effectiveness of different inflation hedging investments is often researched and reviewed. Attie and Roach (2009) considered both the short and long run hedging properties for different asset classes against unexpected inflation. Their results are presented in the table below. The strength of protection against inflation is represented by the elasticity coefficient; the closer it is to one, the better the hedge against inflation .
9 8

The study found that in the short term, only commodities provided a very good hedge against unexpected inflation. Spot commodity prices tend to increase almost in line with rising inflation. Over the longer term, however, spot commodity prices tend to decline leading to real losses.

Table 1: Short and long run hedging properties against unexpected inflation Asset Cash Nominal fixed interest Equities Short term Interest rates respond gradually, leading to real losses. Bond yields rise, causing price declines and real return losses. Real return losses, but less than for bonds. Long term Partial inflation hedge, elasticity of 0.8. Real losses, with elasticity of 0.1. Real losses with elasticity of -0.2 Real spot price losses, with elasticity of -0.2.

Spot price increases, almost matching Physical commodities inflation. Source: Attie and Roach, 2009

8 9

Attie, Alexander and Shaun Roach, 2009, Inflation Hedging for Long-Term Investors, IMF Working Paper No. 09/90. The Attie and Roache study excluded inflation-linked bonds due to a lack of data.

Notably, Attie and Roach found in both the short and long term, equities are a poor hedge against inflation. Indeed, the authors find that of all the asset classes considered, equities are the least attractive hedge against inflation. This conclusion goes against conventional finance theory that suggests equities represent a claim on the dividend stream of real assets such that when inflation rises, companies pass it on in the form of higher prices. The empirical result that equities are in fact not a good hedge against inflation may be explained by the equity risk premium. As inflation rises, inflation variability also rises. The return on capital will also experience an increase in volatility, leading risk-averse investors to seek a higher equity risk premium and so put downward pressure on equity prices.

Whilst Attie and Roach did not consider direct property, Colonial First State analysis suggests this asset class provides limited protection against inflation . Direct property provided only partial protection (positive real returns but was negatively correlated to inflation) against the inflation experienced in Australia in the 1980s, but provided good protection against inflation since. Direct property is a heterogeneous asset class and its inflation-hedging properties depend on the nature of the investors exposure. In the 1980s, investors exposed to commercial property would have suffered from the commercial property market slump which saw large declines in capital values despite high levels of inflation.
10

The table below shows the correlations of CPI to a range of different asset classes. The results confirm the Attie and Roach research that equities and REITS are a poor hedge against inflation. Unlisted property and direct property provide a good hedge against expected inflation (defined as the Melbourne Institute survey of inflation expectations sourced from the RBA) and CPI but not against unexpected inflation (defined as CPI_t Expect Inflation_t).

Table 2: Correlations between CPI and various asset returns annual returns on quarterly rests to 1981-2009 CPI CPI Exp Inf Unexp Inf Aussie Equities Aussie Bonds AREITS U-Prop U-Infra DP 1.00 0.43 0.83 -0.25 -0.01 -0.17 0.28 -0.35 0.14 1.00 -0.15 -0.21 -0.41 -0.30 0.43 -0.25 0.32 1.00 -0.15 0.24 0.00 0.04 -0.23 -0.04 1.00 -0.13 0.75 0.13 0.50 0.34 1.00 0.05 -0.36 0.28 -0.36 1.00 0.31 0.41 0.49 1.00 0.05 0.96 1.00 0.13 1.00 Exp Inf Unexp Inf Equities Bonds AREITS U-Prop U-Infra DP

Source: IRESS, Mercer/IDP, CFS Research

10

Hartigan, Luke, 2010, Hedging your bets: How unlisted property can help guard against inflation, CFSGAM.

The best inflation hedge As the Attie and Roach paper discusses, there are several ways that investors can obtain some level of protection against inflation. The natural question to ask is: what is the best asset to hedge inflation? The answer to this will depend on the individual investors circumstances (as per th e typical disclaimer about general financial advice). Differences in the desire to hedge expected and unexpected inflation will result in a different investment choice. It also pays for investors to be aware of shifting risk around their portfolio. One of the problems in the lead up to the global financial crisis was that investors reduced their default risk but increased the leverage and liquidity risks in their portfolio. It is possible to reduce inflation risk without a large reduction in expected returns. Direct property holdings often have this characteristic. However, these can be illiquid and often require large amounts of capital for the investment. Only investors that can bear this liquidity risk, and have the available capital set aside, should consider this as a potential hedge for inflation. Moreover, whilst it is stating the obvious, property needs to be sold, while bonds mature. In contrast to all other asset classes, the inflation-linked bond is specifically designed to hedge inflation over the life of the instrument. The most common type of inflation- linked bond (ILB) is a capital indexed bond (CIB), where changes in CPI are reflected in the principal value of the bond. So if the CPI was 2.5% and the principal value of the bond at the start of the year was 100, by the end of the year the principal value would move up to 102.5. Coupons payable after the end of the year will be calculated on the adjusted base payment of 102.5. In other words, not only does the base payment move with inflation but also the coupon payment, which is calculated on the adjusted principal. Thus, CIBs provide a direct hedge against inflation. In contrast, nominal bonds (or fixed-interest bonds) retain a principal value of 100, so they do not provide a direct hedge to inflation. Inflation-linked bonds are, therefore, the only asset class that directly references inflation. These bonds, whose coupon and/or principal payments are indexed to a specific measure of inflation, provide investors with a fixed long-term real yield that is free from the risk of inflation in both the short and long term, against both unexpected and expected inflation. The table below summarises the inflation hedging qualities of several different asset classes. Table 3: Inflation hedging qualities of several different asset classes. Asset Class Cash Nominal fixed interest Inflation-linked bonds Equities Property Physical commodities Source: Colonial First State Global Asset Management Unexpected inflation Poor Poor Very good Poor Limited Very good Expected inflation Good Good Very good Poor Good Poor

Apart from maturity matching the bonds to the liabilities, the only other shortcoming of the ability of an inflation-linked bond to provide protection against inflation is the appropriateness of the particular index used to match inflation. The index used may not perfectly match the liability profile of the investor. This difference is referred to as basis risk and applies equally to other assets used to hedge inflation. For example, the spending pattern of a retired household differs from a household that is not retired. This difference is reflected in the weightings attached to each sub-group in the Aged Pensioner Index.

The chart below shows how the weighting pattern in the CPI differs to the index specifically constructed by the ABS for aged pensioner households.

Source: ABS 6463.0 - Analytical Living Cost Indexes for Selected Australian Household Types, Dec 2010

The spending needs of a retiree are clearly different to that of the average consumer. As the above chart shows, the weight accorded to health, food, clothing and footwear is significantly greater for an aged pensioner household than it is for an average household. Similarly, the weighted attributed to education, financial and insurance services, housing and transport is significantly less.

The other benefit of using inflation-linked bonds to hedge inflation, however, is that they are the only asset class that provides protection against both expected and unexpected inflation. Some other assets, such as commodities, tend to hedge current inflation but fail to adjust the return for expected inflation in the future. Consider an inflation-linked bond that has a duration of 10 years. Changes in unexpected inflation are reflected in changes in headline CPI. In Australia, inflation-linked bonds are indexed to Weighted Average of Eight Capital Cities: All-Groups Index, more commonly known as CPI so this change is easily captured. Changes in expected inflation, however, are captured by the

10

movement in the yield on the inflation-linked bond. All else equal, for every 0.1% increase in inflation expectations, the yield on the inflation-linked bond declines by 0.1%, and the return on the inflationlinked bond increases by around 1%. This is the compensation for the expected increase in inflation over the term of the portfolio. The known unknown Many investors fully understand the ideal of matching the time of their hedges but are concerned about the cost of this hedge. This is often stated as the real return is too low. Often, the evidence used to support this thesis is the current state of economic conditions and the likelihood of inflation picking up in the near term. If the main concern is to hedge inflation, however, timing the market in an effort to wait for rates to normalize is dangerous.

It is possible, for example, that higher realised inflation would be accompanied by lower real rates. This type of stagflation scenario could occur in the US, for instance, given the extent to which government debt is forcing fiscal austerity measures, thus hampering productivity growth, at the same time as the Federal Reserve is keeping interest rates at record lows in order to encourage risk taking behaviour in a post financial crisis environment.

The risk-reward trade-off needs to be considered in every investment. If an asset does not provide the right hedge, risk is still present. Investors should demand an expected return high enough to compensate for that risk. If there is a need or desire to remove all of the risk, only the risk free rate can be expected. For investors seeking protection against inflation, the more this risk is hedged out, the lower is the expected real rate of return.

It is never a good idea to buy insurance after the fire has already started. If inflation starts to become an issue, inflation-linked bonds could outperform many other asset classes as more market participants seek the inflation insurance this sector provides. In the scenario where realised inflation increases and real rates move higher, the wisdom of waiting will be highly dependent on the company portfolios current allocation.

The table below illustrates how inflation-linked bonds perform against other fixed interest products in Australia. To minimise the impact of duration we have used the 0-10 constrained index produced by UBS for the nominal and inflation-linked comparison. As can be seen, inflation-linked bonds outperform nominal bonds and cash in a rising official interest rate environment and have performed on par, if not slightly better, than nominal bonds and cash over all time periods considered.

11

Table 4: Performance of inflation-linked bonds against other fixed interest asset classes Average annual returns (%) Aug-96 to Jan-11 Rising rates Nominal bonds Bank bills
3 1 2

Falling rates 10.90 8.80 6.40 24%

Total 6.80 6.84 5.52 60%

10 yrs 5.70 6.10 5.50 71%

5 yrs 5.80 5.70 5.80 57%

3 yrs 6.80 6.60 5.50 58%

4.80 5.90 5.20 78%

Inflation-linked bonds % Time ILB>Nom

1Nominal: UBS Government 0-10 Index 2Real: UBS Government Inflation 0-10 Index 3Bank Bill: UBS Bank Bill Index. Source: Colonial First State Global Asset Management, UBS Data as at 31st January 2011

History of inflation-linked bonds All G7 governments now issue inflation-linked bonds, but the first to start issuing its current programme was the UK in 1981. The largest market for linkers in the world is the Treasury InflationProtected Securities (TIPS) market, issued by the U.S. Treasury. Since its inception in 1997, the TIPS market has grown to approximately $600 billion in outstanding debt, or roughly 40% of the global inflation-linked market. Outside of the G7, by far the largest issuer is Brazil. The supply of inflationlinked bonds in Brazil, and other Latin American countries, arises out of the historic need to raise debt in times of extremely high and volatile inflation. Globally, government issuance of inflation-linked bonds is forecast to top $3,000bn this year three times the amount issued in 2008.

As the diagram below shows, the first inflation-linked bond in Australia was a semi-government bond issued in 1983. The first Commonwealth Government inflation-linked bond was issued in 1985. The size of this Treasury issuance was small, just four bonds valued at $100 million. Two of these issues were capital-indexed bonds (CIB), while the other two were rarer interest-indexed bonds (IIB), paying a fixed coupon plus an inflation accrual on the principal every period (the principal, however, was not adjusted for inflation at redemption). As the Australian governments fiscal situation improved sharply in 1988, the Treasury ceased issuing the bonds.

The government resumed its issuance program in 1993 before closing it again in 2003, again in response to the budget moving back into surplus.

12

Source: Colonial First State Global Asset Management

The re-emergence of inflation-linked bonds in Australia The government re-opened the inflation-linked bond market in 2009 noting it is very much committed to the continuing development of this market . Having begun with a strategy of tailoring issuance to identified market demand, the government has since moved to a more scheduled issuance program. Despite expectations of a return to budget surplus in the coming few years, the government has stated a preference to allocate around 10-15% of new issuance to inflation-linked bonds as a very clear statement of both our belief in the product and our commitment to the further development of the domestic indexed market. In addition, to attract offshore investors to the sector, changes were announced in September 2009 to remove the 10% interest withholding tax levied on foreign buyers of Australian bonds. This has helped to place a floor in demand for Australian sovereign inflation-linked bonds.
11

Source: AOFM as at 30 April 2011

11

Australias experience with indexed bonds, Economic Roundup, Winter 1997, Australian Treasury.

13

The size of the Australian inflation-linked bond market is currently $28 billion. Of this $28 billion, just over $24 billion is issued by State or Federal Government. Approximately 70% of the Treasury issued inflation-linked bonds, however, are held by overseas investors. The remaining $4 billion is issued by the private sector or supranationals. We expect the total market to grow to $45 billion in the next 5 years. The post-retirement market A recent report by Rice Warner
12

calculates the size of the post retirement market to be worth $365

billion currently. This is expected to grow to over $500 billion in 5 years time and to over $1 trillion in 15 years time. In 15 years time, the post-retirement market is expected to account for over 35% of the total superannuation market. The average account balance for a 50-54 year old pre-retiree is currently $100,900. This is expected to grow to $132,800 in 5 years time and to more than double, to $203,500 in 15 years time.

The post-retirement part of the investment lifecycle is becoming increasingly important. If trustees are to adopt the Cooper 7.4 recommendation the availability of instruments needs to change.

The focus of this paper has been on the need to protect retirees against inflation in retirement. The best way to do that is by investing in inflation-linked bonds. Currently, the amount of inflation-linked bonds on issue in Australia amounts to $28 billion. The amount of government inflation-linked bonds, the most liquid in todays environment, on issue is $17.3 billion. This equates to 10% of the total amount outstanding of Treasury bonds in Australia.

Whilst the inflation-linked bond market is liquid today, if trustees conform to the recommendation made in the Cooper Review and make even a small, say 10%, allocation to inflation-linked bonds, this would require a total inflation-linked bond market size of $36.5 billion significantly more than what it currently is. Efforts are underway to emphasis this point to the government. Conclusion Ageing demographics and rising life expectancies is necessarily increasing the focus on post retirement investment strategies in Australia. Of the three main risks that an investor faces in retirement, inflation risk appears to be the least considered. Despite the availability of liquid, market based instruments, few post-retirement products adequately hedge inflation risk for their members. Far too many superannuation funds believe equities provide the necessary hedge while others rely on illiquid assets such as property or infrastructure. Inflation-linked bonds provide the best hedge against movements in price level because it is the only asset class that directly references inflation.

12

Superannuation Market Projections, Rice Warner, June 2010.

14

References 1. Attie, Alexander and Shaun Roach, 2009, Inflation Hedging for Long -Term Investors, IMF Working Paper No. 09/90. 2. Hartigan, Luke, 2010, Hedging your bets: How unlisted property can help guard against inflation, Colonial first State Global asset Management , Property Viewpoint. 3. Norman, David & Richards, Anthony, 2010, Modelling inflation in Australia, RDP 2010 -03. 4. Review into the Governance, Efficiency, Structure and Operation of Australias Superannuation System, Final Report (June 2010). Available at www.supersystemreview.com.au 5. Australias Future Tax System (2009) 6. Sherris, Michael and Wills, Samuel, 2007, Financial Innovation and the Hedging of Longevity Risk, Working Paper July 2007, University of New South Wales.

15