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Pensions Week - Should schemes be more concerned about inflation or deflation dangers?
Personal View by Alex Pocock
(24 August 2009)
There is a significant risk of longer-term inflation that could be far more damaging to pension schemes than short-term deflation
We have seen the lowest base rates in the Bank of England’s 300-year history and a programme of quantitative easing has started, all in the hope of stimulating demand and avoiding deflation. With such a strong focus on deflation it may seem strange to be warning of the dangers of inflation, but there is a significant risk of longer-term inflation that could be far more damaging to pension schemes.
In an attempt to avert long-term deflation, monetary policy has been eased to an unprecedented degree. Although we are seeing headline deflation, it is hoped that the current stimulus will prevent this evolving into a damaging spiral.
In a deflationary environment, pensions linked to inflation would not decrease; the 0% floor on most inflation-linked pension increases would become highly significant. Asset values could fall while liabilities remain static, leading to deteriorating funding levels. Pension schemes paying fixed increases would feel particular pressure as the real value of these pensions increases.
The most challenging part of a strong economic stimulus is its eventual removal. There is a strong risk that current monetary policy could lead to higher future inflation if this removal is not handled appropriately.
The government has taken on a vast amount of debt in order to finance the bailout of the financial sector. Similarly, the British public have historically high levels of personal debt, and transactions in recent years have increased the level of debt within corporate capital structures. With such widespread public and private debt, a period of inflation may be viewed as a politically suitable way to reduce the burden of servicing such debt.
If inflation took off, we would see sizeable increases to inflation-linked pensions, with the largest impact on fully inflation-linked liabilities. The effect on capped pension increases would be less. It is however the impact on, typically uncapped, salary increases that could for some schemes have the most damaging impact and could even lead to further scheme closures.
Schemes with a high proportion of capped or fixed pension increases may find a period of higher inflation beneficial. With the right mix, assets could continue to grow while benefits remained capped at their lower levels. Funding positions would improve, but such circumstances would be painful for pensioners who would see a significant fall in the real value of their incomes. Those schemes with a high proportion of active members or fully inflation-linked pensions could see a severe deterioration in their funding position unless they are invested appropriately.
Trustees and other investors must not ignore the potential for long term inflation by talk of deflation. They should look at their liabilities carefully and invest to protect against long-term inflation as well as shorter-term deflation, taking into account any caps and floors on pension increases.
For the full article on the Pensions Week website please click here