Pension schemes should start thinking about potential deflation risks and make contingency plans to avoid a repeat of the issues seen amid the 2022 gilts crisis, LCP has said.

The Office for National Statistics (ONS) confirmed yesterday (18 September) that inflation had held steady at 2.2 per cent in the year to August.

LCP noted that, as implied future inflation goes below 2.5 per cent, schemes’ liabilities tend to become less sensitive towards inflation, as pension decreases are often floored at 0 per cent.

At this point, schemes that hold index-linked gilts tend to become over-hedged on inflation, with schemes in this position likely start selling their index-linked gilts to return their inflation hedging to the desired levels.

However, LCP warned that as schemes begin to sell their index-linked gilts, there is downward pressure on the price of index-linked gilts, and implied inflation drops further, taking down the price of index-linked gilts with it.

This means that, once again, schemes become overhedged on inflation, and so begins the vicious cycle.

And as pension schemes hold more than a third of gilts available in the market, LCP warned that the “massive” sell-off could have huge ripple effects through the market, mimicking the 2022 gilts crisis.

Given this, the firm argued that now is the right time to start thinking about deflation risk and making contingency plans.

“Deflation is often the least thought about systemic risk, especially given that high inflation has been the issue of focus in recent times,” LCP analyst, Surendra Ravikumar, said.

“As counter-intuitive as it might seem, pension schemes should be a lot more worried about the implied future inflation in the market rather than current inflation levels – if this implied inflation becomes negative, pension schemes could face the risk of a deflation spiral.

“This is the right time for schemes to start thinking about the potential risk of deflation and to make contingency plans. Being prepared for different eventualities is a key lesson we all learned from the 2022 gilt crisis.”

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