Inflation protection for pension scheme benefits

This is about to change. According to the Bank of England, current Inflation is 9 per cent (target 2 per cent), which represents a considerable threat to UK pension scheme obligations, as well as retirement incomes.

Pension schemes will be considering how they can update their investment strategy, such as diversifying assets to protect themselves and maximise returns.

Core infrastructure, often overlooked by schemes, should be considered in the conversation.

Managers will be considering the inflation sensitivity of the asset mixes in their default portfolios amid potentially long-term high inflation rates

Problem for schemes

Equities, often the core component of scheme portfolios, are challenged by rising inflation.

The valuation of growth companies, for example, are based on future profit expectations, which increased inflation has dampened at present.

The value of fixed interest securities, another core component of scheme portfolios, erodes in times of high inflation. To compound things, the accuracy of inflation hedging becomes more difficult when inflation is high.

While defined benefit pensions do have some degree of protection against inflation, this protection is usually capped — eg, at 5 per cent.

With inflation widely expected to reach 10 per cent this year, below-inflation pension increases look set to become the norm. This will mean that pensioners with DB pensions will be worse off in real terms.

Trustees will be considering the investments that may best position them for a sustained phase of moderately higher inflation, without having to switch to niche markets such as precious metals or cryptocurrencies.

Outperformance in times of inflation

Schemes could try solving this problem by diversifying equity investments across different countries and industries, such as with exchange traded funds on broad equity indices.

And indeed, the MSCI World, for example, has performed 4 percentage points a year (6.2 per cent) above the average inflation rate as measured by the US consumer price index since 1999.

However, the infrastructure sector dwarfs this performance when compared with inflation. As measured by the NMX Infrastructure Composite, the sector returned 9.9 per cent a year over the same period, about 7 percentage points more than the average inflation rate.

In fact, it is in times of high inflation when infrastructure stocks show their full strength. When the average annual inflation rate is above 3 per cent, for example, the average excess return of infrastructure stocks over the MSCI World is 8.1 percentage points.

Even when inflation rates trend lower, say between 2 and 3 per cent, it still delivers 3.7 percentage points of outperformance a year.

‘Core’ is best

Schemes looking to integrate infrastructure stocks in their allocation will be challenged by the fact that an applicable definition of “infrastructure” does not exist in the market.

If you search for infrastructure companies via third-party data providers, a whole host of companies come under this banner, many of which fall into the area of “infrastructure-related services”.

The specific needs occupational schemes, however, require those stocks that are classified as core infrastructure. For example, a toll road operator belongs to the core infrastructure sector, while a logistics company — as a user of these roads — can be classified as an infrastructure-related service.

Asset class qualities

Note, that if the index — measured by the NMX Infrastructure Composite — also included infrastructure-related services, the performance would deviate markedly.

Core infrastructure has special economic characteristics that other infrastructure-related services companies lack, including high market entry barriers, positive economies of scale, and a natural monopoly position.

Combine these with highly predictable cash flows due to the stable demand for their services, and the positive side-effect of this is the higher average credit ratings and lower default rates.

This was evident during the Covid-19 pandemic, when operators of power grids or cell towers fared much better than power producers, for example.

Surges in inflation, particularly over cumulative years, can have a significant impact on pension schemes.

Managers will be considering the inflation sensitivity of the asset mixes in their default portfolios amid potentially long-term high inflation rates.

Infrastructure stocks appear to offer better protection than the equity and bond markets — provided exposure is limited to core infrastructure.

Robin Jakob is managing director at LPX AG