'We're not in Kansas anymore' - but can inflation fears be put to rest?

Our viewpoint

In the Wizard of Oz, Dorothy travels far and wide trying to return home to Kansas. Her path is fraught with many dangers. It’s only at the end of the film when she learns that the true power to get home has been with her all along – three clicks of her magic slippers and she’s home.

Back to pensions with a jolt (bear with me). 

Market RPI inflation expectations over the next 15 years have been rising for months and are now a whisker below 4% per annum.

That means if you buy investments aiming to perfectly protect your money against inflation, your investment will only be a good one if RPI is above or around 4% on average, for the next 15 years. It’s widely expected that prices are about to spike, but we’re not just talking about the next 1 or 2 years, but 15 years.  For the final 6 of those 15 years, RPI is expected to be calculated using a different formula which should give around a 1% lower answer than before – but the market is still stubbornly suggesting RPI is likely to be 4% over this time.

An individual might buy these investments to give them some peace about their cost of living. Gas bills just gone through the roof? No problem, your portfolio's gone up to match it.

Many pension schemes are also worried because they'll have to pass on cost-of-living rises to their pensioners. To protect themselves, they love buying those investments with inflationary pay-outs. Need to pay your pensioners 4.8% (RPI, August 2021) more this year than last? No problem, your investments just gave you the same amount.

There aren't many investments to go round and there's a big scramble to buy them, making them even more expensive. Remember, you now only win this game if RPI stays at or above 4%.

But what if schemes already have an alternative which protects them against spiralling inflation? It doesn't apply for every scheme, but for the majority it has been in their possession, and bar the briefest of appearances in 2011, sitting quietly in the background since 1991. It's called the "pension increase cap".

If in any year inflation is higher than 5%, 3%, or in some cases even 2.5%, a majority of schemes don’t pay their pensioners increases higher than their scheme-specific “pension increase cap”. You might say it’s tough for the pensioners who still have to pay their gas bills, but it was written into their rules, and they had access to what they were signing up for. And they’re doing better than other pensioners, who don’t get any increases at all.

Inflation-protection investments still have their place.  Not least because benefits for most deferred members are capped in a different way, meaning they may increase sharply if we have a few years of very high inflation.

But the “doomsday scenario” of a return to 1970s-style inflation may not be as scary as you first think, if a high proportion of increases to pensioner benefits are capped at 5% pa or lower.

So, just like Dorothy’s slippers, is now time to review whether the best inflation protection is the pension increase cap that’s been with us all along?

Three actions I suggest to help you be on top of the inflation game:

  1. Know your limits: when it comes to what you’re willing to pay for inflation protection. Our investment team can help you think about the inflation risk of your scheme and properly account for caps in your scheme.
  2. Own the volatility: For the inflation protection you do have, put in place a robust and responsive hedging strategy. One great side-effect of rebalancing liability hedging strategies regularly is that these often naturally buy when inflation protection is cheap and sell when it’s expensive, which could make a tidy profit as well as reducing risk.
  3. Blue sky thinking: Whether it’s a “Pension Increase Exchange”, or updating pensions which currently receive the antiquated RPI increase so members get a CPI increase which much better reflects their rises in cost-of-living, other options are out there for many schemes to manage their liabilities and/or their inflation exposure.