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The Actuary The magazine of the Institute & Faculty of Actuaries

European pension funds worried about impact of inflation shocks

European pension funds are increasingly worried about the potential impact of inflation shocks on their portfolios as markets remain volatile, according to Mercer’s annual European Asset Allocation Survey. The survey of over 1,100 European pension funds with assets of over €550bn found that 80% of respondents are now more concerned about the threat of increasing inflation than they were last year and many are taking action to protect their assets.

Mercer’s survey shows that 38% of the funds concerned about inflation are planning immediate action to protect against any shocks. Eighteen percent are planning to increase their allocation to inflation-linked bonds, 5% are allocating to inflation-sensitive assets and 3% to inflation swaps. The remaining 12% have taken some other action such as establishing processes to exploit opportunities as they arise either through the use of discretionary management or by introducing a series of triggers that, once hit, will increase their allocation to inflation bonds or swaps.

Tom Geraghty, Mercer’s head of investment consulting for Europe, Middle East and Africa, commented: "The last 12 months have been characterised by a general sense of unease and rapid swings from optimism to fear and back again. The use of loose monetary policies and quantitative easing has created the ideal environment for the re-emergence of inflation, which is a cause for worry for many pension funds.

"Protection, through acquiring inflation hedging assets (such as inflation bonds and swaps), looks to be expensive and there is a risk that such investments provide ‘insurance’ for events that never actually happen. Pension funds also need to understand the extent to which their liabilities are affected by higher inflation. In some cases, inflation caps may mean that higher inflation is less negative for pension schemes than might be expected."

The results of the Mercer survey show that both Ireland and the UK have a bias to equities, although this continues to decrease year on year. In the UK allocation to equity is currently at 47%, down from 50% in 2010 and a 20 percentage point decrease since the survey started in 2003. Most of the recent UK reduction has happened within the domestic equity portfolio, down from 28% in 2009 to 21% now. Irish funds have seen a record reduction in average equity allocations since 2010, dropping from 59% to 50%. Allocation to equities across the rest of Europe remains low, particularly for many funds in Germany (5%), due to local regulatory restrictions. In the Netherlands, pension funds hold an average equity allocation of 26% and in Switzerland 30%.

Over the next 12 months, Mercer says that 23% of European funds and 35% of UK funds plan to reduce their exposure to domestic equities, whereas around 20% of all funds plan to increase their exposure to domestic government bonds and/or non-traditional asset classes.

"The steady move away from equities has meant that larger plans throughout most of Europe now have significant exposures to domestic government bonds," said Crispin Lace, partner in Mercer’s Investment Consulting business. "However, with bond yields at historically low levels the desire is now to diversify the bond exposure to increase the level of yield within this portfolio. Many pension funds are therefore considering alternative debt markets such as high yield and emerging market debt and also some opportunistic ideas such as distressed and mezzanine debt."

Going forward, the consultant says that European funds are looking to increase their strategic allocation to a wide range of non-traditional asset classes. On average 22% of European funds intend to increase their allocation to emerging market debt (11% of UK funds). Over 6% of European funds plan to further diversify across debt markets through allocating more to distressed debt (7% of UK funds).

"With anaemic growth expected in many western economies, the growth rates of emerging economies continue to attract attention. And pension plans are focussing on more than just emerging market equities to ensure they tap into the real growth potential in these markets," said Mr Lace.

The full survey can be found here.