Inflation has reached its highest level in almost a decade. What steps should you be taking?

Our viewpoint

It’s been hard to miss the headlines around inflation over the past few months. 

What’s perhaps less obvious from the news stories is that whilst a short-term inflation shock is highly likely (and we’re already experiencing the start of it), there’s the potential for longer-term, sustained inflation as well. The chart below shows the approximate cost of hedging inflation over the next 15 years – up by over 1% pa since the start of the pandemic (and still rising).

Cost of hedging inflation over the next 15 years

Based on our assumptions around the typical hedging levels of UK pension schemes (80% hedged on accounting bases), our analysis suggests that the rise in inflation over the past year has already added around £15bn in pension costs for UK companies due to 2021 inflation-linked pension increases.

Far higher costs (potentially an additional £35bn or more) could be incurred if current expectations for future inflation are realised (compared to expectations that were priced in by the market at the start of the year).

So, what does this mean for your company’s pension obligations and what steps could you take?

1. Check you remain comfortable with your scheme’s hedging strategy

We generally see inflation risk as “unrewarded”, meaning you’re unlikely to benefit with any real certainty by taking a gamble on whether the market has over or under-priced inflation.

By hedging inflation risk, you can avoid drastic swings on your balance sheet and reduce the risk of future contribution requirements soaring out of control.

You can also free up your risk budget, which could be better utilised elsewhere – e.g. investing more in return-seeking assets like equities, bonds, property, which will help bridge the gap to a stronger funding position by letting the scheme’s assets do the heavy lifting.

2. Avoid miscommunications

Many schemes have a strategy to be “100% hedged” against inflation risk. Looking in the detail, it often turns out the scheme’s policy was to “hedge 100% of assets” (or put another way, 100% of the funded liabilities). But what about the deficit (or the unfunded liabilities)?

Well, this often isn’t hedged at all. While this sounds alarming, it is common practice for UK DB schemes and in some circumstances could result in the sponsor having to significantly increase their contributions if inflation rises. To put numbers to this – a scheme that is 85% hedged (e.g. 85% funded and 100% hedged on assets) could see their recovery plan contributions increase by around 20% or more if inflation rises by 1%.

By increasing the hedging to also cover unfunded liabilities, you can have greater certainty on what you’ll need to pay in the future and reduce the likelihood of an unwanted surprise at the next Actuarial Valuation.

3. Rebalance your inflation hedge if it has drifted away from the agreed target

Pension Scheme benefits include complex features, such as caps on inflation-linked pension increases (5% pa is a common cap).

When inflation expectations rise (as we’ve seen over the past year), this results in reduced inflation sensitivity as the likelihood of hitting the cap increases. See the chart below for an illustration of this in practice.

When inflation expectations rise

LDI portfolios often won’t automatically account for this. That means your “100% hedge” ratio might now have drifted up to 110-120% or higher, if your liabilities are now less sensitive to inflation. Revisiting the hedge, and rebalancing back to target, is a great opportunity to sell some of your inflation-linked assets at a time where they have recently increased quite significantly in price.
For more on this topic, we’d suggest a quick read of a blog written by our colleague, Tim Camfield.

Recognising the challenge that inflation poses and following these three steps will keep your pension scheme well prepared for the period of high and fluctuating inflation that we will be living through for the foreseeable future.

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