Defined benefit (DB) pension schemes should pay more attention to optimising their inflation hedging strategies due to current volatile inflation rates, according to LCP.

The firm warned that some schemes that had taken inflation risk “seriously” may be over hedged and could look to make adjustments, while others’ inflation hedging may be incomplete.

Those schemes with incomplete inflation hedging could lead to unexpected bills when inflation rises, with LCP analysis finding that the impact of increasing inflation has already added around £15bn to the pension costs of DB schemes.

An additional £35bn could be added to pension costs if the rise in inflation proves to be more than “a temporary phenomenon”, LCP noted.

LCP also warned that schemes that believe to be fully hedged could still be at risk to a rise in inflation, as some see being fully hedged as to mean hedging 100 per cent of funded liabilities but not the deficit.

“This would mean that a scheme that is 85 per cent funded and 100 per cent hedged on assets could see their recovery plan contributions increase by around 20 per cent or more if inflation rises by 1 per cent,” the firm noted.

Meanwhile, schemes that previously completely hedged against inflation could now have an inflation hedging ratio of 110-120 per cent due to higher inflation and caps on inflation-linked pension increases.

Schemes that are over hedged should consider rebalancing their hedging approach and selling some inflation-linked assets, LCP stated.

“The resurgence of inflation could lead to big bills for many companies, especially where their pension scheme had not taken steps to protect against rising inflation,” LCP partner, Phil Cuddeford. 

“Even if you think you have the right protections in place things can change quickly in either direction – up or down. Reviewing hedging strategies is a must, and this could also free up risk budgets to invest in more return seeking assets such as equities, private credit and property.”

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