On the go: Defined benefit schemes are exposed to £200bn in losses from inflation strategies as index-linked gilts reach record high prices, new research has shown.
Analysis from PwC revealed that for most of 2020, a pension scheme would have had to invest around £170 in a 20-year, index-linked gilt to receive just £100 on maturity in today’s terms, which would deliver a negative real return of 2.5 per cent a year.
The accumulated impact of the issue across the UK DB pension scheme universe is £200bn in lost value, the consultancy noted.
PwC stated that increased demand is leading to a hike in prices of index-linked gilts, which, despite the announcement from the government that the retail price index will be reformed to follow the lower consumer prices index from 2030, has not fallen to take account of reduced future maturity payments.
The consultancy explained that most scheme benefits are linked to inflation to some extent, meaning there is a strong desire from trustees to cover that exposure, whether by directly investing in inflation-linked assets or other approaches.
This translates to DB schemes having £550bn tied up in RPI-linked gilts, making up the bulk of the whole index-linked gilts market.
However, considering that the total UK DB pensions asset base is £1.8tn, the demand is far outstripping the available supply of index-linked gilts, driving up the price of these assets.
Chris Venables, pensions partner at PwC, noted that a possible solution for the issue could be for the UK government to “issue significantly more index-linked gilts to address the supply and demand imbalance, so pension schemes can achieve a reasonable level of return”.
“Currently, new issues run at only about £25bn a year. But larger new issues could exacerbate the distortions we are seeing,” he said.
“Investment in index-linked gilts diverts money away from other income-generating assets which can generate positive real return.”
Venables said another option would be to make changes to pension regulations and policy to enable schemes “to invest more freely in other income-generating assets, and not feel tied to chasing government debt”.
This would include ensuring the Pension Regulator’s new regime for funding pension schemes “is not designed with reference to gilt yields”, he noted.
He added: “If pension schemes continue to invest in negative, real-yielding assets, then either there will be insufficient funds to pay all future pensioners, or their sponsoring employers will need to pay more money to subsidise the negative real returns. This could come at a cost of more than £200bn.”
