Nadine Wojakovski details the ways pension funds are tackling the inflation challenge

The recent increases in CPI and the surprise spike in inflation in the last two years has made trustees change their focus and consider the importance of the long-term structural picture of their pension schemes. There have been two factors around inflation that have been of concern for them. The first is the directly observable increase in CPI and the second is the long-term view that with the rapid growth in demand in the emerging/developing economies there will be higher than average inflation rates.

Cardano UK CEO Kerrin Rosenberg says firstly and most importantly, pension funds need to think about inflation risk in the context of their liabilities. Although it is true that most UK pension funds have inflation linkage in their liabilities, the extent and nature of the inflation linkage can differ quite substantially from scheme to scheme.

The vast majority of UK DB schemes have significant inflation linkage in their liabilities and it is very important for them to decide how much inflation risk should be run, says Rosenberg. But, he points out that it is not so much the current level of inflation that affects schemes, so much as the level of future expected inflation. “If you have fully inflation-linked pensions then a one per cent increase in current inflation may increase your liabilities by one per cent. However a one per cent increase in expected future inflation will increase your liabilities by between 15 per cent and 20 per cent.”

One radical step a small number of pension schemes are taking is to convince the membership to accept a lump sum in return for foregoing any future inflation linkage. Technically, this means those schemes don’t have much of an inflation link going forward.

Inflation swaps
For the majority of others Rosenberg believes the risk can best be controlled by using inflation swaps. These swaps involve the pension fund paying fixed payments to a bank in return for the bank paying an RPI linked payment back to the fund. At present these swaps trade at around 3.5 per cent, meaning that pension funds can effectively lock into an inflation rate of 3.5 per cent over the next 20 years. He says: “This seems to us to be a reasonably attractive thing to do, as it is very difficult to forecast what will actually happen to RPI over this long time frame. What’s more, pension funds can transact these swaps without adjusting their physical asset allocation, so one doesn’t need to take a decision on equities or bonds to do this.”

For example, a pension fund may have assets of £500 million and liabilities of £800 million. This fund is on risk regarding inflation for the full £800 million of liabilities. A 1 per cent increase in inflation expectations could cause the liabilities to rise by 15 per cent, or £120 million. So the pension fund really needs an inflation swap covering the full £800 million. If the fund had that investment it would also rise by £120 million in value, thereby protecting the fund from the impact of inflation. Inflation swaps are viable for pension funds with assets of at least £200 million but smaller schemes can access similar benefits via pooled funds.

Broader based solutions – active management
Using inflation swaps is a strategic move that considers the whole pension fund’s assets and liabilities. By contrast, recently there has been a move by some schemes towards protecting inflation through active management for a small proportion of the total fund, say 10-20 per cent of the portfolio. (This can also be done in conjunction with using inflation swaps, as above).

The challenge for DB schemes is that as they are maturing, their payment obligations are becoming more real and profound and they need to look at their asset allocation mix to see how to respond, notes Morgan Stanley Investment Management head of portfolio solutions Joe McDonnell. Historically, the response was to buy government bonds. However, today, the problem is that underfunded schemes have to generate returns well above CPI to make sufficient returns, meaning that pension funds need to look at broader based solutions.

The increase in pension fund liabilities from persistent inflation is a big challenge which requires an “aggressive response”, says Kames Capital joint head of fixed income Stephen Jones. “We believe that a more aggressive and holistic approach to investing in index-linked markets produces better results.” He says that generally pension funds don’t have enough inflation protection in their asset mix, and where they do have inflation-linked assets they are often in restrictive investment vehicles that inhibit investment manager action and alpha generation around them. Consequently the investment managers launched the Kames Capital Inflation Linked Fund, in July 2010. The £235 million fund is more dynamic in terms of asset allocation and active management in pursuing the inflation agenda in the belief that this “multi asset approach” can significantly outperform the index linked benchmark over time.

Their approach is to take “as broad a view as is available”. They assess assets that are driving inflation or benefiting from inflation to help counter the inflation threat for pension funds. “We think inflation first in all our investments and include currency, equities and commodities in the investment asset mix. We invest both with a top-down asset allocation viewpoint and from a bottom-up perspective,” explains Jones. For example, with currencies, the way the fund can mitigate the inflationary impact of the weak sterling is not to hold all assets in sterling but to take exposure to stronger overseas currencies. This flexibility has proved useful as sterling has stayed weak as the Bank of England has kept interest rates low and growth has been subdued. In short, its strategy is to continually look to crystallise profits, adapt to market moves and price adjustments, and adjust the mix of assets where it can find better returns.

Morgan Stanley, on the other hand, creates bespoke solutions of a mixture of traditional asset classes and alternatives dependent on the pension funds’ requirements. Equities will not necessarily do well when inflation is strong plus they are volatile and soak up too much risk, says McDonnell. So they look at other asset classes which will grow the portfolio yet at the same time have sensitivity to inflation. “No asset class does that on its own, so they need a combined portfolio which collectively gives high sensitivity to inflation but also delivers decent returns when inflation is benign,” he adds.

The range of strategies that do this, include liquid and illiquid investments. Examples are core real estate, global opportunistic real estate, infrastructure, equities where business is focused on gas and oil such as energy stocks, emerging market private equity in and around the consumer, broad energy commodities such as gas and oil, senior loans, global inflation-linked securities and currency. “Individually they have links with inflation,” notes McDonnell, “but collectively they have a robust response to inflation and will also have significantly less volatility than global equities.”

On a collective basis McDonnell says about 20 per cent of a portfolio should be invested in this category of index-linked assets. “It is an implicit inflation-linked portfolio, which is a series of long-term real assets that can achieve the CPI++ objective.” For each one per cent increase in inflation the portfolio should increase by two or three per cent he says. The other benefit is that even when inflation is not particularly high these assets will supposedly deliver good returns. Conversely, a portfolio that will struggle in a low inflation environment is one that has a lot of fixed income and broader based equity stocks.

Whatever route a scheme takes, Buck Global Investment Advisors chief investment officer Simon Hill urges caution and common sense. He warns that pension funds should be aware that it is not possible to get total protection from inflation and says the solutions should not be too prescriptive as they may not be appropriate when economic or financial relationships change. “The inflation risks to which pension schemes are exposed are limited by statute, and those rules may change at any time,” he advises. “There is no panacea so you need to be pragmatic and intelligent.”

Written by Nadine Wojakovski, a freelance journalist

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