DC schemes urged to consider default portfolios’ inflation sensitivity

Defined contribution (DC) pension schemes should consider the inflation sensitivity of the asset mixes in their default portfolios amid potentially long-term high inflation rates, according to LCP partner, Paul Gibney.

Speaking at the LCP DC and Financial Wellbeing Conference, Gibney noted that inflation sensitivity should be assessed in all phases of the default strategy.

In the growth phase, he noted that many schemes’ defaults were already likely to be relatively well inflation protected, as they are probably largely invested in equities, and should consider property and infrastructure allocations.

“Whilst they [equities] are not a perfect match for inflation, they do normally prove inflation resilient over the longer term and in the growth phase members do have time on their side,” Gibney stated.

“If not already present in the mix, considering allocations to property and infrastructure also make good sense to me, given the contractual nature of the cashflows from them as well as the potential inflation linkage.”

For the later growth phase, Gibney said he wanted to examine any non-inflation sensitive elements of the asset mix.

“For example, if there was a significant allocation to corporate bonds and see whether it remained appropriate or whether it should potentially be down-weighted,” he noted.

Moving on to address the end phase, Gibney said that the most appropriate asset mix depended on the default’s objective.

“For annuity options, the best mix of bonds depends on the annuity objective,” he continued.

“In broad terms, if it’s a fixed annuity then fixed bonds, and inflation annuity, inflation bonds. If you have a fixed annuity default, it might make sense to consider whether that’s appropriate for the future.

“For a drawdown option, it’s got to maintain purchasing power. In a potentially higher inflation world, understanding inflation sensitivity of that end-phase portfolio is really important. For example, if there is a significant allocation to credit, it’s long dated and fixed, then it is vulnerable to inflation. So, you might want to think about shorter-dated credit options or replacing some of that fixed-credit exposure with floating-rate alternatives, such as asset-backed securities.

“Make sure that, in your default options, there is sufficient inflation protection. I think that applies particularly to any lump sum default you have and to the lump sum elements of any other defaults.”

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