DB schemes face return losses of £200bn due to inflation-linked strategies

UK defined benefit (DB) pension schemes' approaches to securing inflation-linked returns on assets could be exposing them to losses of around £200bn, according to research from PwC.

The firm noted that DB schemes currently have £550bn tied up in gilts linked to the retail price index (RPI), making up the bulk of the whole index-linked gilt market, with most schemes benefits linked to inflation to some extent, meaning there is a strong desire from trustees to cover that exposure, such as by investing in inflation-linked assets.

However, PwC pointed out that the total UK DB pension asset base is £1,800bn, "far outstripping" available supply of index-linked gilts, which is in turn leading to prices being driven up by a supply and demand imbalance.

This “relentless” pension scheme demand means that buying these assets now could deliver a negative real return, according to PwC, with the same applying for any pension fund already holding index-linked gilts.

The analysis showed that for most of 2020, a pension scheme would have had to invest around £170 in a 20-year index-linked gilt to receive £100 on maturity in today’s terms, delivering a negative real return of -2.5 per cent per year.

In addition to this, the UK government announced in November 2020 that RPI would be reformed to follow the lower Consumer Price Index including owner occupiers’ housing costs (CPIH) measure from 2030.

PwC clarified however that the price of index-linked gilts has not fallen to take account of reduced future maturity payments.

As such, an investor would currently pay £180 to receive maturity in today’s money terms, with PwC estimating that the accumulated impact of the issue across the UK DB pension landscape is equal to £200bn in lost value.

PwC pensions partner, Chris Venables, commented: “The UK government could issue significantly more index-linked gilts to address the supply and demand imbalance, so pension schemes can achieve a reasonable level of return. Currently new issues run at only about £25bn a year.

“But larger new issues could exacerbate the distortions we are seeing. Investment in index-linked gilts diverts money away from other income-generating assets which can generate positive real return.

“Another option would be to make changes to pension regulations and policy to enable pension schemes to invest more freely in other income-generating assets, and not feel tied to chasing government debt.

“This would include ensuring The Pension Regulator’s new regime for funding pension schemes is not designed with reference to gilt yields.

“If pension schemes continue to invest in negative real-yielding assets, then either there will be insufficient funds to pay all future pensioners, or their sponsoring employers will need to pay more money to subsidise the negative real returns. This could come at a cost of more than £200bn.”

PwC global head of pensions, Raj Mody, added: “It’s odd that the market has hardly reacted to the news that the RPI formula will be nearly 1 per cent a year lower from 2030.

“Pension fund investors are still prepared to pay significant premiums for inflation protection via index-linked gilts, despite record price levels. As things stand, there is a downside risk to pension funding levels for schemes with strategies heavily dependent on this asset class.”

“Schemes should also look again at the inflation forecasts underpinning their funding and investment targets. The market may not currently be a good predictor and this affects a whole raft of decisions for trustees and company sponsors.

“Of course, they have to take a holistic approach. They have to weigh up the costs and risks of protecting themselves against volatility.

"Plus you can’t just isolate inflation, or environmental, social and governance (ESG), or any other topical issue such as the government’s recent call to action on investments.

"You have to develop an all-round strategy which in the end meets your outgoing pension payment commitments with a manageable level of risk.”

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