Inflation jump poses ‘a real challenge’ for pension schemes

Inflation rose from 2 per cent in July to 3.2 per cent last month, according to consumer price index figures from the Office for National Statistics, exceeding both the Bank of England’s targets and the expectations of economists, who had expected a rise of up to 2.9 per cent, according to a Reuters poll.

Though certain transient effects are expected to disappear from the figures in relatively short order, such as the impact of the government’s ‘eat out to help out’ scheme, the ONS cited a range of other impacts including “shortages of supply chain staff and increased shipping costs, coupled with demand increases following the lifting of national lockdowns”, which continue to push up inflation.

The BoE’s upper forecast has inflation rising further to 4 per cent later this year, though some economists have predicted it may even exceed this estimate – and there is a broader debate around whether the phenomenon is transitory or will prove lasting, with potentially difficult consequences for some UK pension schemes.

Sustained high inflation could be a real challenge for many pension schemes. Trustees should consider not only how robust their investment portfolio would be in a more inflationary environment, but what this would mean for the sponsor covenant and their ability to support higher costs

Carl Hitchman, Buck

Inflation hedging

Industry specialists told Pensions Expert that the precise effect will be determined by the extent of the inflation hedging each individual scheme has undertaken, as well as the way in which benefits are linked to inflation.

Chris Arcari, senior investment research consultant at Hymans Robertson, said that as outlined in the Pension Protection Fund’s Purple Book, “most schemes provide inflation indexation (linked to the retail price index or CPI) on benefits accrued after April 5 1997, while around 50 per cent provide inflation indexation on benefits accrued before April 6 1997”.  

“However, most schemes will be less than 100 per cent hedged on inflation – therefore, higher realised and implied inflation will result in a greater increase in liabilities relative to assets, and so generally an increase in deficits,” he said.

Carl Hitchman, chief investment officer at Buck, shared a similar position. He said: “Whether higher inflation leads to higher costs will depend in part on the level of inflation hedging in place, with those that have implemented higher hedging levels generally being better protected.

“As well as the direct impact on pension benefits, inflation may also have a material impact on asset prices. In times of high inflation, for example, fixed interest bonds are less attractive.”

Graham McLean, senior director in Willis Towers Watson’s retirement business, cautioned that some benefits accrued before 1998 “do not come with inflation protection – and neither does the PPF compensation in respect of any benefits accrued during that period, whatever the scheme would have provided. Higher inflation leads to a bigger erosion in the purchasing power of these pensions”.

Looking long term

Should higher inflation prove not to be transitory and last into the long term, the level of inflation-hedging will still be important, but other factors will determine how pension schemes are impacted, while there could be consequences for the lifetime allowance cut and the value of tax relief on pension contributions.

Hitchman told Pensions Expert: “Sustained high inflation could be a real challenge for many pension schemes. Trustees should consider not only how robust their investment portfolio would be in a more inflationary environment, but what this would mean for the sponsor covenant and their ability to support higher costs.

“In terms of the investment portfolio, there are three key issues I would highlight. The first is whether to increase the level of inflation hedging (if not already fully hedged), taking into account current market pricing. Given the supply/demand dynamics for inflation hedging, the decision on this is not straightforward,” he continued.

“The second is whether schemes have sufficient liquidity to meet cash calls from their leveraged liability-driven investment portfolios, should interest rate expectations rise in response to inflation fears. Without appropriate liquidity ladders in place, trustees could be forced to sell some of their growth assets, which could affect longer-term return expectations and hence funding costs.

“The third is how robust the current growth portfolio is likely to be in an inflationary environment – scenario testing is particularly helpful here.”

McLean added that many schemes are “already anticipating higher rates of inflation than for the previous round of funding valuations, but will still need to consider the implications of published inflation if that leads to bigger uplifts at the next pension increase date, as it raises the baseline benefit level to which future increases will be applied”.  

“Not many schemes have August as the reference month for pension increases – September is much more common and everyone will now have one eye on those figures. Prices were higher in September 2020 than in August 2020 (partly because ‘eat out to help out’ had finished),” he said.  

“The CPI price level will need to rise by about 0.4 per cent month on month for September’s annual rate to be as high as the 3.2 per cent recorded for August,” he added.

Chris Jeffery, head of inflation and rates strategy at Legal & General Investment Management, was more optimistic about long-term prospects, although he warned that a return to “1980s-style dynamics” would require “a self-reinforcing feedback loop between prices and wages”. 

“There are two necessary conditions for that to develop: higher inflation expectations, and workers with the power to leverage those expectations into higher pay. There are certainly anecdotes of pay pressure in parts of the labour market, but we don’t see the case for that becoming widespread given elevated unemployment rates. Without a wage-price spiral, inflationary pressure will be rapidly snuffed out."

RPI vs CPI

McLean noted that the current wedge between the RPI and CPI – 1.6 per cent – is “much bigger than normal”.

“That means that even though RPI is due to converge with CPI including owner occupiers’ housing costs from 2030, the precise wording of scheme rules – and whether schemes and sponsors are prepared to use the flexibility they have, or test it in the courts – can make a meaningful difference to pension increases in the meantime”.

Arcari likewise cited the alignment of the two inflation measures as a key structural factor to consider.

As RPI will be aligned with CPIH from 2030, one could assume a “target” level of inflation implied by the difference between conventional and index-linked gilt yields of around 2.25 per cent a year post-2030, he explained. 

With index-linked gilts still aligned with RPI pre-2030, this compares with an assumed target-implied inflation of around 3.25 per cent a year, assuming a gap between the measures of 1 per cent a year, he added.

On this assumption, implied inflation “looks expensive at terms up to 10 years, with most forecasters suggesting UK inflation is unlikely to average 3.8 per cent per annum (current level of 10-year implied inflation) over the next 10 years, and remains expensive at the longer end of the curve, where levels of implied inflation could be more impacted by RPI reform”, Arcari continued. 

“However, while we note the risk of a derating of index-linked gilt valuations, and hence asset values, we are also cognisant of the strong institutional demand that can mean deviations from fundamental value in this market can be persistent.”

He added that, where liabilities are concerned, RPI reform has the potential to reduce liabilities where benefits were previously indexed to RPI, though he noted that many schemes already have increases linked to the CPI.

Rob Pace, senior solutions strategy manager at LGIM, noted that although there is limited publicly available data around CPI linkage, “we estimate that 20 per cent of total scheme liabilities could be CPI-linked”.