Inflation fears and pension funds
Chair: Inflation is sitting at the top of investors’ agendas and the topic is dividing the crowd into various camps. Are you an inflation hawk, sharing the table with the likes of Larry Summers, urging the White House to scale back its stimulus program, otherwise the US may find itself in an inflationary episode not seen in a generation? Former chief economist at the Bank of England (BoE), Andy Haldane, holds a similar dreary outlook. He recently said that he believes once the so-called inflation genie is let out, it may prove difficult to get back into the bottle.
Or perhaps you are an inflation dove, sitting amongst Christine Lagarde and Jerome Powell, who insist that higher inflation will prove nothing but transitory. The common thread amongst this group is that they believe the risk of removing stimulus too soon outweighs the risk of igniting a little inflation.
Or finally, you may find yourself in a third camp which almost has a pandemic tone about it. It’s all about the data, dates, or both.
Whichever camp you fall in, how worried are, or should, pension funds be about the prospects for inflation and are they doing enough to deal with this potential risk?
Rose: By pure nature of UK defined benefit (DB) schemes, inflation has always been one of the clear risks they have had to deal with, and one they’ve actively managed. It’s probably a case where macro views have been something you delegate down, because trying to determine asset returns from macro views is difficult. Even people who spend a lot of time and effort on it, and have a good track record, find it difficult to do as we’ve seen in the positioning of any number of hedge funds and macro funds – they very easily go wrong.
Most of our clients are well hedged against the inflation exposure that comes with DB liabilities – they have large exposures to long-dated inflation expectations, and hedge those, and have ongoing hedging programs as their liabilities change and as inflation expectations change.
So, from a DB point of view, the inflation linkage is fairly well contained and well hedged.
From a defined contribution (DC) point of view, the difficulty with putting risk management in place is, if you look at what DC members actually do, very few take up index-linked pensions, or they take up even fixed-rate pensions. The demand there is much more for a nominal sum, rather than for an inflation linked cashflow of some type.
Thinking about what might happen in the future, you need to look at the combination of both inflation and growth, because central banks over last ten/twenty years succeeded on inflation, but they failed on growth, so a more balanced approach between the two is probably a good thing. That said, there are a lot of risks in the European approach of trying to keep inflation very low, but also by keeping growth low as well.
Pickford: Most of our DB clients also have their direct inflation risks well hedged. My concern lies more around the indirect risks of an inflation spike on the real value of growth assets. We don’t think inflation is going to be high indefinitely. Some of the shock to inflation is transitory, and driven by supply bottlenecks, which will eventually ease. However, we suspect some is driven by strong growth too, so tighter monetary policy might be needed. Central banks have plenty of room to tighten policy if necessary, but are growth asset prices necessarily pricing that risk in?
So, whilst direct risks are well managed by most DB schemes, that doesn’t mean we can be totally relaxed about inflation risks.
O’Brien: Across our client base, on the DB side, we see high hedge ratios too and a good understanding of where there is basis risk, and where there is exposure beyond what market instruments can deliver.
It is right that pension funds and the sponsors behind them think about inflation because their time horizon now is more immediate
Inflation hedging gets more complicated when you look at the continent because, first of all, where there is inflation linkage among pension funds, it often has an element of discretion associated with it, certainly on the post-retirement side. Often there are caps and collars that are cumulative by nature, and that is difficult to assess, difficult to model, but also changes people’s perceptions. They may say, for example, “I only have a max of 10% exposure to inflation here, so why should I worry about bringing something potentially expensive on board?”
To pick up on Philip [Rose’s] comments on DC, the loss of purchasing power among DC members approaching maturity has never really been tested because we’ve lived in a low inflation environment for the entire history of the DC market. As we see the IORP risk function and other governance enhancements starting to take shape around the continent, a lot of thinking will need to be done about how to protect DC benefits.
Mody: To pick up on the point about inflation definition, in the context at least of DB schemes, we are not talking about unlimited retail price inflation; we are talking about a capped and collared version of that – limited price inflation.
Another force that is moderating the underlying inflation exposure which DB funds have is, at least in the UK, the movements happening from 2030 to redefine RPI to a CPI basis of calculation. All of that serves to contain the exposure that pension funds have, although it is still there of course.
It is right that pension funds and the sponsors behind them think about inflation because their time horizon now is more immediate. If you look at how pension funds were investing in the ’80s and ’90s, you could afford to have a long term time horizon in order to get inflation-beating returns, but now, when you look at the £1.8 trillion worth of assets that are sitting in UK DB schemes, about £50 billion of those are being paid out every year in pensions. That’s a much more clear and present exposure to inflation. It’s not some conceptual risk that you have to manage over the next decade or two – you have to manage it this year, next year, and the year after. That’s a new feature of managing inflation in the 2020s that was different from decades ago.
Also, there are more options for pension funds today, and for their members, when it comes to reshaping benefits and that is a relative novelty when you look at the multi-decade lifetime of pension schemes. That didn’t happen historically, but from the turn of this century many pension schemes have given members options to reshape the inflation around their benefits.
So, in a situation when inflation might be high, and because of the fair value exchanges that go on when members take these options, they’ll be paid good value when there’s a concern about future inflation risk. Just at the time when inflation exposure might be increasing for pension funds, it might be a good platform and a time for when members are prepared to take that trade and trade out inflation risk for a flat pension.
Finally, we need to think about retirement and an individual’s income needs in a more modern way than used to be the case. I think an inflation linked pension for the rest of life, say from the age of 70 onwards, is not a very good fit for a typical person’s likely income needs.
Putting long term care aside, generally speaking, because of health, mobility, lifestyle and so on, if you think about older people’s lifestyles, you will have a certain spending pattern for your 60s. It probably does then reduce for a decade into your 70s, and then it reduces again into your 80s. You’re not doing in your 80s what you might have been doing in your 60s. So I’m not sure you need an inflation linked pension in your retirement. You might do very well to have a flat pension which maintains its purchasing power in respect of the actual expenditure and outgoing that you might need to have as an individual over time.