Inflation – “unexpected financial impacts for DB pension schemes”

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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 inflation figures published this morning which show CPI inflation at 10.1% and RPI at 12.6%, Jonathan pointed out that the consequences of inflation for DB pension scheme funding can be wide ranging depending on their individual circumstances.

For example:

  • Legislation provides a cap on the amount of inflation protection which schemes are legally required to provide to member benefits; even when inflation reaches double digits, scheme liabilities may rise much less than this; for example, for pensions in payment there is no legal requirement to provide indexation on pre 97 service (except for rules on GMPs), and post 97 service may be capped at 5% or 2.5%; if asset values can at least match inflation, but liabilities are capped below inflation, the net effect can be positive for scheme funding, other things being equal;  
  • On the other hand, 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;
  • 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.

Jonathan Camfield said:

“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.  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”.