Indexing Long-Term Financial Contracts

Abstract

SynopsisThe prime purpose of the paper is to present the case for the issue of longterm index-linked stocks by the government and by other borrowers, for the issue of index-linked life assurance and annuity contracts by life offices and for the index-linking of pension scheme benefits, all of which the author believes are possible and would be beneficial to all parties.Part 1 of the paper uses the methods of statistical time-series analysis to study the way in which inflation has behaved in the U.K. over the long period 1661 to 1980 and over various shorter and more recent periods. While prices were far from static in the period up to 1914 the average change was nevertheless almost nil. However, during the 20th century prices have generally risen and in recent years this rise has accelerated. It is possible that the series has become unstable, and hyperinflation will result. It is certain that no one statistical model can satisfactorily “explain” the movements of prices. Future uncertainty is now very great.The author concludes from this that index-linking oflong-termcontracts, i.e. adjusting for price changes after they have occurred, is more satisfactory to both parties to the contract than to guess at a single fixed inflation rate and build that into the contract.Part 2 discusses the issue of long-term index-linked government stocks. It demonstrates the uncertainty attached to fixed interest borrowing and lending, and the harmful effect on the future PSBR of the government's present funding methods. The author discusses the Wilson Committee's view on index-linking, and supports their suggestions of tax changes to make practicable the issue by companies of index-linked loan stocks. Index-linked house purchase loans are also advocated.In Part 3 the author presents the advantages to life offices and their policyholders of policies with index-linked premiums and benefits, and discusses some of the complications of such policies, in particular the tax obstructions for certain types of policy.In Part 4 the author suggests that index-linked pensions are both desirable and possible for all pension schemes, not only those in the public sector, though possibly they should start at a reduced level. Evidence is presented to show that “negative real returns” on ordinary share investment were a temporary aberration of the mid 1970s, and that in more recent years ordinary shares have shown very satisfactory real returns, which may very well continue. Ordinary shares have nothing to fear from index-linked stocks, and pension funds should be able to earn satisfactory real returns on any assets other than long-term fixed interest stocks.