Pensions, endowments, and other institutional investors are underestimating their liabilities because actual inflation is far higher than official measures, according to a soon-to-be-released study from real estate investment firm Unison Homeownership Investors.
Unison argues that a change made in 1983 to the Consumer Price Index has left inflation underreported. “Underreporting of inflation has resulted in an estimated 20 percent gap between actual underlying inflation and the official measure,” according to the report.
Founded in 2007, San Francisco-based Unison manages investments in residential homes for pensions, endowments, and other institutions. As one example, a pension would provide a consumer with a home down payment in return for an ownership stake in the residence.
For pensions and other big investors, a true measure of inflation is critical to understanding future liabilities. Many corporate pension plans, for instance, have implemented a version of liability-driven investments, whose goal is a specific return above inflation. Rather than hold a portfolio that maximized risk-adjusted market returns by incorporating equities and other riskier assets, many corporate plans have restructured their portfolios to earn just enough to meet the promises they’ve made to retirees.
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“Inflation is the most significant number for a pension plan,” says Rayan Rafay, head of portfolio management and chief operating officer of Unison, which was founded in 2007. “In particular, after the financial crisis, corporate pension plans across the world moved away from a target return objective, say 7 or 8 percent, to a goal based simply on inflation.”
Rafay explains that this is generally expressed as a small return above CPI.“Their objectives to meet their obligations became directly tied to inflation,” he says.
With its report, Unison aims to address some of the structural problems in the current inflation calculations. “Everyone knows that inflation is important, but no one knows how it is tabulated,” says Rafay, who adds that pensions and endowments aren’t looking beyond the official numbers to see what return objectives they really need to achieve.
The report’s authors argue that the way the housing component of inflation is calculated has led to 34 years of underreporting true inflation. Unison decided to study this phenomenon when it saw a disconnect between reported inflation and the rising cost of housing. Over the past five years, for instance, reported inflation has been low, but real estate prices have been rising significantly.
In its study, Unison found the reason for the disconnect in a change that dates back to the early 1980s. In 1983, the government started using the cost of renting a home rather than the cost of a home purchase, which had included property taxes, insurance, mortgage interest, and other costs. Over the subsequent decades, rents rose far less than the cost of owning a home. Rafay argues that the government missed the real estate bubble forming in the middle 2000s because of the calculation change in 1983.
Unison says the approach has resulted in massive underreporting of inflation because the true cost of housing is not reflected in official measures. “We moved from the cost of housing to the cost of living in the house,” says Rafay.
The report highlights risks for institutional investors of not understanding how CPI is calculated and why it’s understating their obligations. Rafay stresses that pensions need to beware that it could change again.
“There’s a risk that the calculation will be changed at some point in the future,” he says.