The impact of a prolonged period of high inflation on pension scheme finances could be unexpected, according to LCP partner and inflation expert Jonathan Camfield.
Commenting in the wake of new UK inflation figures published this morning which show CPI inflation at 10.1% and RPI at 12.6%, Camfield pointed out that the consequences of inflation for defined benefit (DB) pension scheme funding can be wide ranging depending on their individual circumstances.
He noted, for example, that UK legislation provides a cap on the amount of inflation protection that schemes are legally required to provide to member benefits – even when inflation reaches double digits, scheme liabilities may rise much less than this.
He said that if asset values can at least match inflation, but liabilities are capped below inflation, the net effect can be positive for scheme funding.
On the other hand, Camfield said, the benefits of statutory caps on minimum inflation protection may be less for schemes where “scheme rules” provide for more generous inflation protection.
In particular, based on today’s figures, an uncapped inflation increase would be around 5.1% (CPI) or 7.6% (RPI) higher than a 5% cap; where schemes provide such benefits this will be more expensive, he added.
The impact of inflation on scheme funding will also depend substantially on the extent to which schemes have hedged their exposure to inflation. Until relatively recently, many schemes will have taken steps to ensure that they hold assets which substantially rise in line with inflation or used derivatives so as to reduce the negative impact of a rise in inflation on the other side of their balance sheet.
However, one impact of recent market turmoil is that some schemes will have reduced their hedging and may now therefore be more exposed to longer term persistent inflation.
“When it comes to DB scheme funding, the impact of inflation will vary hugely from scheme to scheme. But perhaps counterintuitively it’s not always bad news. For some schemes, and particularly those with limited and capped exposure to indexation, high inflation can actually be good news, especially if the assets side of the equation is boosted when prices rise,” Camfield said.
“The more challenging impact comes for schemes with uncapped inflation increases, particularly if those schemes are not fully inflation protected in their assets. With the inflation outlook being so uncertain, it is important that schemes understand and review their exposure to inflation risk on a regular basis,” he concluded.
Most DB schemes ‘are doing well’ despite market turmoil, says XPS
Charlotte Jones, senior consultant at XPS Pensions Group, said: “Contrary to reports over the last couple of weeks, from a funding perspective most defined benefit pension schemes are doing well despite the market turmoil brought on by the mini budget.”
XPS’s DB:UK funding tracker estimates that schemes currently have over £160bn of surplus funds following the sharp rise in gilt yields seen in the past few weeks.
“With schemes’ funding improving during a cost-of-living crisis, pensioners of defined benefit schemes may ask whether those excess funds could be used to help them pay their bills this winter. At XPS we’re seeing pension schemes looking at various options to support their members through this challenging period and especially to see if they can help those members that will see their retirement income fall in real terms,” she said.
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