LONDON, 05 March 2015 - Aon Hewitt, the global talent, retirement and health solutions business of Aon plc (NYSE:AON), is urging pension schemes to consider hedging inflation risk while short-term inflation remains low  and is driving down the cost of the longer-term inflation hedging assets used by pension schemes.

Inflation has been falling largely due to the decline in the oil price. For a typical UK pension scheme, where approximately 70-80% of liabilities are inflation linked, this creates an opportunity to remove risk as the cost of buying the assets needed to hedge future inflation has also come down.

Daniel Peters, partner at Aon Hewitt said: 
“There is a real opportunity and urgency for pension schemes to act now. Future inflation is uncertain - even the Bank of England’s forecasts for the next two years paint a very unclear picture – but the risk pension schemes face is a real one. When we see short term periods of deflation or concerns about deflation as at the moment, it presents opportunities to look at hedging long term inflation risks.

“Another consequence of the fall in the oil price and inflation is that the Bank of England and the US Federal Reserve are under less pressure to raise interest rates to manage short term inflationary pressures.  While some schemes may be hesitant to fully hedge their interest rates right now, we believe they simply cannot afford not to increase their inflation hedging.”

From a practical perspective, schemes which would like to increase their inflation hedge in isolation (without hedging interest rates), will need to have a liability driven investment (LDI) mandate.  Other traditional hedging assets such as a regular bond portfolio and index-linked gilts, do not allow schemes to separate the return linked to interest rates from the one linked to inflation. Liability-driven investments, by contrast, offer pension schemes the opportunity to single out the inflation component and benefit from the cheaper current market conditions.

Calum Mackenzie, principal consultant at Aon Hewitt said:
“Since inflation started falling, we have advised an increasing number of schemes to separate their inflation risk from interest rate risk by increasing their inflation protection. LDI mandates enable schemes to use inflation swaps to pay a fixed rate of inflation, and receive whatever inflation turns out to be – at the moment this fixed rate looks attractive.  This allows trustees to isolate the inflation decision and doesn’t tie up capital in the same way that a regular bond portfolio would.

“Hedging inflation on its own does of course carry risks. Schemes must keep in mind that there are two components to hedging a liability; hedging inflation, and hedging interest rates.  You need to do both eventually.  What we’re saying is that now is a great time to do part one, but if you do not already have interest rates adequately hedged, you must remember to come back and do part two. We have worked with clients to help them understand how much extra inflation risk they can hedge compared to their interest rate risk”

Almost a year ago, Aon Hewitt released analysis which suggested it was a good time for pension schemes to hedge against interest rate risk. Those schemes which did not act to bolster their hedge at the time may now be feeling the cost of being under hedged by approximately 20% in funding terms.  This demonstrates how sensitive pension scheme liabilities are to movements in interest rate risk. While expectations remain low and hedging assets look cheap, inflation risk, just as interest rate risk, should be addressed to reduce any threat to the stability of the scheme.

Daniel Peters said:
“In summary, the recent move in the oil price and the knock-on impact on short term inflation prospects, has provided a meaningful opportunity for pension schemes to look at hedging their exposure to inflation.  Even if pension schemes are not acting on interest rates at the moment, this is worth looking at. But note, an LDI mandate is an essential tool for taking advantage of inflation pricing.  Physical bond mandates simply won’t do the job.”

Notes to Editors

Media Contact:
Colin Mayes                                           Marina Jane Sanchez
Aon Hewitt                                              CNC
01372 733689                                         020 3219 8811
colin.mayes@aonhewitt.com                    marina.jane-sanchez@cnc-communications.com

About Aon Hewitt
Aon Hewitt empowers organisations and individuals to secure a better future through innovative talent, retirement and health solutions. We advise, design and execute a wide range of solutions that enable clients to cultivate talent to drive organisational and personal performance and growth, navigate risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability and wellness.  Aon Hewitt is the global leader in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide.  For more information on Aon Hewitt, please visit www.aonhewitt.com

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About Aon
Aon plc (NYSE:AON) is the leading global provider of risk management, insurance and reinsurance brokerage, and human resources solutions and outsourcing services. Through its more than 66,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative and effective risk and people solutions and through industry-leading global resources and technical expertise. Aon has been named repeatedly as the world’s best broker, best insurance intermediary, best reinsurance intermediary, best captives manager, and best employee benefits consulting firm by multiple industry sources. Visit aon.com for more information on Aon and aon.com/manchesterunited to learn about Aon’s global partnership with Manchester United.