News analysis: Schemes have been warned they need to protect themselves against fluctuations in inflation despite rates falling to the Bank of England’s target level.
In December, inflation hit the BoE’s 2 per cent target, as measured by the consumer price index, for the first time in four years.
Rather than being all or nothing, it’s better if [hedging] is drip-fed
Murray Taylor
Defined benefit schemes' future pension promises are linked to inflation, and the rates are used by actuaries to project the value of a scheme’s assets and liabilities and its ability to pay out future benefits.
In isolation, lower inflation is generally a good thing for schemes as liabilities rise at a slower rate, but very low levels can be a sign the economy is struggling, said Simeon Willis, principal consultant at consultancy KPMG.
However, schemes should be cautious about reviewing their investment strategy based on decreased inflation.
“It’s when longer-term expectations fall [that] pension schemes really benefit,” he said. Long-term expectations of inflation movement have largely remained unchanged despite the recent fall in rates, experts have said.
Inflation rate expectations have been around 3.5 per cent for quite some time now, said Lee Dodds, investment partner at consultancy LCP.
“What is driving pension scheme decision-making is the long-term expected level of inflation and cost of hedging that,” he said.
For schemes to feel a real impact it would require the economy to recover at a surprising rate, so much so that the BoE would increase interest rates.
If the central bank feels it can increase base rates it will signal that the country is well and truly into recovery, and that will cause a rise in yields and make bonds more attractive, Willis added.
Now is an opportune time to hedge against inflation, said Murray Taylor, consultant in the investment team at JLT.
“Rather than being all or nothing, it’s better if [hedging] is drip-fed into the scheme,” he said.
Schemes should also consider their funding level when deciding to what extent they hedge against inflation, Taylor said, as schemes that are nearing full funding would want to take less risk and put in place greater protection.
Investors could also turn to other assets with a legal obligation to pay inflation-linked returns, to reduce their exposure to fluctuations in the market, said Bernard Abrahamsen, head of institutional distribution at M&G Investments.
“These could include index-linked corporate bonds, property leases or ground rents, housing association loans and infrastructure debt,” he said.
