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Public DB Plans: Pursuing Inflation Protection Without Compromising Return Prospects

Embedding inflation protection within equity exposures may help public defined benefit plans achieve return targets.

Cost-of-living adjustments rank among the most valuable benefits offered by public defined benefit (DB) pensions. But the need to tie benefits to inflation often clashes with investment strategies designed to achieve ambitious expected return on assets (EROA) targets. However, we believe an option exists – a capital-efficient approach in which traditional equity mandates are converted into synthetic equity backed by physical Treasury Inflation-Protected Securities (TIPS).

Unlike corporate plan sponsors for whom liabilities generally fall when inflation rises – the commensurate increase in the discount rate reduces liability valuations – public DB plans typically face rising liabilities when inflation picks up as cost-of-living adjustments get factored in (all else equal). On the other hand, most public pension plans hold few, if any, assets that provide direct inflation sensitivity. They are thus unlikely to get near- term inflation-driven asset appreciation to offset higher liabilities.

Inflation has been low due to depressed economic activity amid the COVID-19 pandemic, but in our view the risks of inflation overshoots ahead have meaningfully increased due to massive coordinated monetary and fiscal stimulus, rising debt levels, and accelerating de-globalization. Also, after undershooting its 2% inflation target since 2012, the Fed would likely welcome above-target inflation.


Ideally, plan sponsors could gain exposure to inflation-sensitive assets (like TIPS) without having to lock-in the returns for these assets, which are meaningfully lower than public DB plans’ EROA targets. This type of “have-your- cake-and-eat-it-too” objective could be accessible to plan sponsors who believe a capital-efficient approach may be appropriate for their plan.

In order to maintain a significant exposure to equities or other risk assets to pursue return targets while also obtaining exposure to inflation-sensitive assets, we believe public DB plans should consider whether it may make sense for their plan to convert their traditional (physical) equity mandates into synthetic equity backed by physical TIPS collateral. As Figure 1 shows, this approach could help plan sponsors capture equity-like returns on top of realized inflation.

Figure one shows a series of boxes arranged left to right as an equation: equity beta, plus inflation protection beta, plus potential alpha, all add up to equal portfolio return. The box with equity beta shows a bar, whose height indicates the biggest part of the return. Inflation protection beta is made up of shorter bars representing TIPS (U.S. Treasury Inflation-Protected Securities) beta return, less the short-term money market rate. Potential alpha, shown as a short bar, comes from an actively managed TIPS portfolio. The total return is shown as a tall bar on the right, stacked with the various components.

The strategy may provide a number of important potential advantages to public DB plans by:

  • Using the TIPS collateral to provide inflation protection against liabilities. The total equity return can now contribute to funding ratio improvement (as opposed to being reduced by the amount needed to cover liability growth related to inflation indexation).
  • Boosting diversification by adding real duration, which tends to have a low correlation to equity. This could be particularly beneficial in severe market downturns as plan sponsors could source benefit payments from TIPS (which are likely to appreciate if real rates decline) as opposed to crystalizing losses by selling equities.
  • Delivering incremental carry, relative to a traditional equity exposure, to the extent that the combination of the real rate of return and inflation adjustments on the TIPS collateral exceeds the financing rate of the equity derivatives position.


Plan sponsors will need to ensure they can effectively manage the TIPS collateral portfolio and have sufficient liquidity to meet margin calls on the equity overlay portfolio. The strategy also requires regular rebalancing between the equity component and the TIPS collateral as the two fluctuate in magnitude and direction.

A comprehensive approach – equity beta via futures and swaps and TIPS collateral – may help address implementation considerations. We have written previously about the potential benefitsof active TIPS management, and here we note that active management helps investors to position appropriately even in periods when inflation surprises on the downside, for example via the use of inflation swaps.


TIPS are an appealing collateral because they are U.S. government guaranteed, relatively liquid, and have exhibited a low correlation to the equity overlay. Their coupon and principal adjust with CPI inflation, providing a hedge against inflation.

Analysis of the asset class has been constrained by its relatively short history (they were first issued in 1997), but fortunately the Federal Reserve Bank of New York has created a history of U.S. inflation expectations using statistical techniques to derive synthetic TIPS real rates and implied inflation breakeven rates back to the 1970s. We use these data to calculate synthetic TIPS returns and correlations for a more robust historical analysis of the asset class.

We believe TIPS have particularly powerful benefits when combined with equities. As Figure 2 shows, stock-bond correlations tend to increase with inflation, but stock-TIPS correlations decline as inflation rises, boosting diversification benefits.

Figure 2 shows two scatterplots, showing 3-year annualized inflation versus 3-year stock-bond correlation in one graph, and versus 3-year stock-TIPS correlation in the other—for the time period December 1977 to June 2020. Inflation is shown on the X-axis. For inflation versus stock-bond correlation, shown on the left, the plots form upward sloping curve, with its slope steeper at lower rates of inflation. Most plots fall with correlations of negative 40% and positive 60%, and 1% and 10% inflation. On the other graph, on the right, the average of the plots of inflation versus stock-TIPS correlation is a slight downward sloping curve, and almost linear, close to the X-axis. Most plots are between negative and positive 40% correlation, and 1% and 10% inflation.


An investor could combine separate allocations to U.S. equities (S&P 500 Index) and U.S. TIPS (Bloomberg Barclays U.S. TIPS Index) into a single, equities-backed-by-TIPS portfolio.1 The resulting capital-efficient portfolio would amplify the market exposure to each of the two assets without requiring additional capital – i.e., $100 can provide $100 of S&P 500 exposure and $100 of TIPS exposure, less financing costs. (Note, although we use the S&P 500 as an example, the same concept applies to virtually all equity betas.) See Figure 3.

Figure 3 is a line graph showing the hypothetical growth of  $100 of equities backed by TIPS, compared with the performance of the S&P 500 index and U.S. TIPS, over the time period 1997 to 2020. All grew over time, yet bottom near $100 in late 2008 or early 2009. After that, equities backed by TIPS increased at a much steeper rate than the benchmarks, growing to almost $1,200 by 2020. That compares with about $600 for the S&P 500, and $350 for U.S. TIPS.

By applying the Federal Reserve’s history of calculated real rates that pre-date the 1997 advent of U.S. TIPS, we can generate an even more complete data set. Since 1977, in a hypothetical portfolio following this construct the equities-backed-by-TIPS portfolio would have meaningfully outperformed both stocks and TIPS, on a standalone basis (see Figure 4). Not only were absolute annualized returns higher, so too were risk-adjusted returns (the Sharpe ratio). This capital- efficient structure of equity backed by inflation-linked bonds has benefited historically by allowing upside capture in risk-on markets, downside avoidance in risk-off markets, and by preserving purchasing power in periods of rising inflation.

Figure 4 is a line graph showing the hypothetical growth of  $100 of equities backed by TIPS, compared with the performance of the S&P 500 index and U.S. TIPS, over the time period 1977 to 2020. Equities backed by TIPS increased at the fastest rate, particularly after the financial crisis in 2008 and 2009, rising to a value of about $18,000. Over the same period, U.S. TIPS rose to a little more than $10,000, while that of U.S. TIPS rose to about $1,500.

Since 1977, the equities-backed-by-TIPS portfolio would have achieved improved returns, with only modestly higher volatility than equities, and a significantly improved Sharpe ratio (see Figure 5). Inflation beta, or portfolio sensitivity to unexpected changes in inflation, also improved (i.e., it’s less negative). It’s important to note that higher inflation beta is preferable (it has less inflation risk), but does not need to necessarily be positive because it may be suboptimal to hedge all inflation risk, and investors still realize an improvement in beta from -2.48 to -1.39 in this example.

Figure 5 is a table showing returns of equities backed by TIPS, compared with those of the S&P 500 Index and U.S. TIPS, over the time period 1977 to June 2020. Data on return, volatility, Sharpe ratio, ex-ante inflation beta, and equity beta are included within.

If we zoom in on periods of rising CPI inflation, we see the power of combining stocks and TIPS. Since 1977, there have been 126 periods in which the 12-month change in inflation rose by more than 1 percentage point (note: We are referring to the year-over-year change in inflation, not the inflation level). During these periods, on average the equities-backed-by-TIPS strategy outperformed stocks by roughly 5 percentage points as TIPS typically have strong absolute returns in periods of rising inflation (see Figure 6). While this paper focuses on the risk of inflation, deflation is also a possibility, and investors should weigh the risks of a broad range of potential outcomes. Real TIPS yields, which are currently negative, could limit total return from the TIPS portion of the portfolio. However, that does not preclude potential positive contributions from inflation accruals and changes in real yields.

Figure 6 is a table that shows average 1-year returns for equities backed by TIPS, U.S. TIPS and the S&P 500 Index for periods when inflation is rising, from December 1977 to June 2020. Data, which includes 126 periods when year-over-year CPI change is greater than 1%, is detailed in the table.


The risk of higher inflation in the post-COVID-19 world has meaningfully increased. Investors exposed to inflation risk, such as DB plans, have been in a tough spot having to balance the need for returns to meet EROA targets and for inflation protection to hedge risk embedded in their liabilities.

The capital-efficient approach combines equity beta and actively managed TIPS, and aims to meet both needs simultaneously. The stock-TIPS combination may help improve funding ratios by potentially producing improved returns over equity-only allocations, and may do so in a more diversified manner – especially in market downturns when plan sponsors may source benefit payments by selling likely-to-appreciate TIPS as opposed to realizing losses by selling equities. And finally, TIPS are an appealing choice of collateral due to their high quality, relative liquidity, historical low correlation to equities, and as an added bonus, the potential for active alpha generation.

1 The portfolio comprises 100% S&P 500 Index and 100% Bloomberg Barclays US TIPS Index less the 3-month Libor financing cost for the equity derivatives. This does not account for some small hedging and rebalancing costs.
The Author

Rene Martel

Head of Retirement

Daniel He

Portfolio Manager

Georgi Popov

Product Strategist



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