By Alex White, Head of ALM Research, Redington
Normally, if you have an option – an equity put, for example- you’d mark it to market. You’d take the price it trades at and say that’s the value on your balance sheet. In general, not marking to market is dangerous because when you pay out money, you pay out at market price- so you must tend to market prices at some point. There’s also a behavioural point, in that it’s much rarer to ignore market prices that boost the balance sheet. For example, when credit spreads are tight, no-one understates their asset value by pricing their corporate bonds at historic prices. The argument only tends to come the other way, when market prices make the situation look worse.
However, in LPI the market is very illiquid. There is a meaningful backbook of LPI swaps which need marking, so the price exists, but there is very little trading, and bid spreads would be chunky. It’s also driven by things like bank capital charges and other regulation.
So, if it’s not a tradeable market, and it’s skewed by regulation, why mark to it?
Firstly, you have to do something- schemes should not leave benchmarks static. At the extremes, if your liabilities have a cap at 5%, and inflation were 6%, you wouldn’t want to hold a lot of inflation-linked assets. It follows that schemes should do some form of delta-adjusting. So, we can either mark to the market, such as it is, or mark to a model that does not vary with market prices (typically a Black model).
In effect, mark-to-model pricing with a Black or Black-Scholes model implies a belief that deflation protection is overpriced. This may be true, but there are reasons why we should be careful, and why deflation protection should be expensive:
• Pension money is the bulk of the inflation market, and they all have the floor at zero (and most have a 5% cap). If inflation gets close to 5%, pension funds should sell, pulling inflation back down. If inflation gets close to zero, they should also sell, accelerating inflation further away. And while negative long-end inflation may seem ridiculous, so did negative long rates, yet Switzerland proves they can happen. Over the sweep of history, inflation has often been driven by population growth. It follows that long-term deflation should be possible for an ageing economy with declining birth rates which has prioritised limiting immigration.
• Inflation and interest rates are generally positively correlated. This means that when inflation is low, you should expect rates to be lower, and therefore the impact on a scheme would typically be higher.
Neither point means the price is “fair”, or that pensions funds should buy LPI swaps en masse. The point is more about the principle of pricing- there are complicated feedback loops inherent in the market, which make working out the Platonic form of the price very difficult. In both instances, marking to an uncalibrated model essentially means ignoring any effects you didn’t foresee. Taking a view on whether prices are attractive or not is a separate question from whether or not to recognise your liabilities at market prices.
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