What lies ahead - inflation, deflation or stagflation? Christine Senior examines what pension schemes need to do in order to avoid being caught out by new economic realities

Even if the recession is over, its aftermath will take some time to play out. Opinion is divided on the future of the economy and inflation. In the UK the Retail Prices Index (RPI) is currently negative, but is this just a blip? Or will inflation, or even hyperinflation, fuelled by the Bank of England's quantitative easing policy, come back to wreak havoc as it did in the 1970s?

Given the uncertainty, pension schemes face a dilemma in how to plan for the future.
Three possible extreme scenarios face trustees as they consider their strategy: deflation, inflation accompanied by strong economic growth, or stagflation, where inflation rises in the context of an economy that is mired in the stagnation of little or no growth.

Deflation, which while having the virtue of reducing liabilities, still has a negative impact because schemes can't reduce pensions in payment to reflect it. But the effects of a long-term deflationary environment are hard to fathom, since Japan is the only place to have experienced it in recent years.

Inflation may come in two guises. Against a backdrop of an economy that is powering ahead it shouldn't be too much of a problem, says Kerrin Rosenberg, chief executive at Cardano. But in a languishing economy, it is more to be feared. "With weak growth companies don't make profits and equities don't do well - property markets don't perform either," he says. "Index linked gilts do well but they're usually a small part of a pension fund's portfolio."

If inflation spikes up to more than the crucial five per cent level, then pension schemes should not worry unduly, since most liabilities are capped, with inflation linked rises only payable in the range of three to five per cent. But not all benefit payments have this cap, so it depends very much on the structure of individual schemes.

Real interest rates
Alex Koriath, principal consultant in KPMG's investment advisory team, says the key issue for most pension funds is what is happening to real interest rates, and not just inflation.

"What a pension fund should be looking at is not only the level of expected inflation, or break-even inflation, but what they think will happen to real interest rates. That is crucial. If they go down the effect will be negative for pension funds because the present value of liabilities will go up. This can be caused by inflation increases not being passed on through nominal interest rate increases or by nominal rates falling and inflation expectations staying the same."

More important than a sudden rise in inflation, is how long any period of inflation might last. The effect of inflation on assets changes over time. At first if the rise is substantial and comes without warning, most asset classes will underperform, especially gilts, cash and equities.

Tapan Datta, a consultant in the global investment practice at Hewitt Associates, says most asset classes underperform in periods of rising inflation at first, particularly ordinary gilts. However, "a couple of years down the line - it seems counterintuitive - but the longer inflation lasts the more things you wouldn't expect to do well, such as gilts and cash, start to outperform. Equities don't do well except in the very long-term when they are inflation neutral".

Commodities, on the other hand, do well at the start of a period of inflation, since rising commodity prices often are the cause of inflation. But eventually that changes.

"Short-term, commodities are a good inflation hedge," says Datta. "As inflation lasts commodities start to underperform. The reason is rising inflation and higher commodity prices bring about an economic slowdown, and then demand for commodities suffers and after that commodities are a bad hedge."

High inflation?
Rosenberg thinks the good news scenario of high economic growth and relatively high inflation is fairly improbable. The most likely is a period of weak economic growth coupled with some, though not high, inflation, but with material risks of a slip back into recession and higher inflation. None of these scenarios are good news for pension funds.

"Our view is there will be a slow, painful, recovery that takes time to repair the excesses we have lived through. This will probably be a difficult period for equities, and pension funds, which on average have half their assets in equities will find they disappoint."
For Datta the risk of deflation is low. He anticipates that next year the RPI figure will be back in positive territory after the disappearance of some distortions that turned it temporarily negative. He also discounts the likelihood of very high inflation.

"The story over the next two to three years is inflation pressure will be subdued because there is a lot of capacity slack in the economy. Inflation is very unlikely given rising
unemployment, and a weak recovery will be a problem. Beyond the next two to three years there is a risk of inflation outside the level of comfort."

Insurance and risk
Given the uncertainty, trustees who want to protect their fund should make sure that the investment portfolio is properly diversified.

"It comes back to basic principles: they should always be well diversified," says Dan Looney, an investment management specialist at Towry Law. "Some of those diversified investments can do well during times of inflation such as gold and index linked gilts."
But another way for trustees to look at it is to consider inflation's impact as part of the risk budget. Koriath at KPMG says it's important to consider inflation and interest rate risk within the context of a pension fund's total risk.

"If you have a strategy with 50 per cent of your portfolio in equities or growth assets, you find the risk of equity volatility can massively outweigh the interest rate and inflation risk you have," he says. "There is a balance to be had. How much risk can you actually take as a fund and how does interest and inflation risk contribute to the total risk you are taking?"
Rosenberg warns that trustees need to plan for all potential scenarios. Even if their core view is that inflation will remain subdued, they should still consider protecting themselves against the possibility of extreme outcomes: "If you think deflation has a 20 per cent probability, that is quite material. You can't ignore it. You should take measures to protect yourself."

In this situation Rosenberg advocates using derivatives for protection: "You can use options in the equities market and in interest rates. We think they are a powerful tool that trustees should use. You could be wrong and you need something in your portfolio to protect you against both extremes [of high inflation and deflation]."

Rosenberg suggests investors review their portfolios in the context of their view of inflation and economic growth: "If you have 50 per cent in equities you are probably betting on the strong economy scenario returning. If you don't believe that then you should be doing other things with assets."

One of the other things suggested by Rosenberg is to invest in 'distressed' assets, if investors believe the situation will remain tough for some time. "There is a wide range of ways as an investor you can lend money or invest equity capital. It's a different way of taking risk," says Rosenberg.

Distressed strategies create opportunities for investors to make money out of events like company insolvencies. Banks, for example, might be forced to sell good assets quickly at below fair value prices.

Flexibility
Another key consideration for trustees is that rising inflation should prompt them to keep a constant eye on their asset allocation.

They need the flexibility to adapt quickly to a changing scene. Buying, holding and rebalancing is not an option, says Datta. "Initially as inflation rises you should be out of ordinary gilts and cash and into more inflation hedged instruments, but two years down the road if that inflation lasts there is a case for switching some assets back to bonds. You have to remain flexible, review your asset allocation and set a perhaps slightly shorter investment horizon than the long-term that is usual pension fund policy."

This need to be in a position to respond quickly to changing circumstances may mean some changes are necessary in trustees' governance structure. It is particularly important if inflation should jump suddenly. Having a flexible decision-making process in place to enable fast response is vital. Koriath says this is something trustees are already taking on board.

"Pensions funds are realising they need to react more quickly. There are more regular investment committee meetings, or sub-committees being established. Scheme advisers are giving more proactive advice, bringing new ideas to schemes and educating them on potential opportunities in the market. Many schemes are adjusting the governance structure even further, establishing monthly calls or updates from advisers."

As an example, Koriath highlights some opportunities over the last six months for pension funds to take advantage of mispricing of swaps in direct hedging strategies.
"In the past six month gilts have yielded more than swaps, which is an anomaly. Normally swaps yielded 0.3 to 0.4 per cent more than gilts because there is a residual counterparty risk when you are dealing with a bank to earn the swap's LIBOR leg. With the massive market dislocation the situation reversed and gilts yielded half a percent higher than swaps. That prompted (some) funds to reconsider strategies to take advantage of that, to make LDI strategies more flexible and move from swaps to gilts."

But the other aspect of inflation is its effect on liabilities. Trustees may want to consider whether it's possible to mitigate this. One way is to put a ceiling on future inflation-linked rises in pensions, which has to be with the agreement of the membership.
Some clients of Xafinity have already been considering this, according to Rob Hunt, the firm's director of corporate solutions.

"Theoretically you could go to the membership and ask if they would be prepared to give up their pension increase for an increased flat pension. If they have a pension of £100 increasing in line with inflation you offer them a pension of £110 which will remain at that level. With a couple of our clients we have approached the membership and asked for volunteers."

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