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The Actuary The magazine of the Institute & Faculty of Actuaries

Pensions: The tipping point

Since the start of compulsory indexation, inflation has been one of the key risks faced by UK pension schemes. With retail prices index (RPI) inflation recently creeping above the 5% mark for the first time in nearly two decades, trustees and sponsors of some defined benefit (DB) pension schemes are fretting about the impact that increases in inflation could have on their funding positions, with many looking towards reducing their inflation exposure through the purchase of inflation-hedging assets (such as index-linked bonds or swaps).

On the other hand, some pension schemes may find that caps on pension increases mean that high levels of inflation have less of a negative impact on funding levels than might be expected. Indeed, increases in inflation beyond these caps could in fact be beneficial for schemes, as asset values continue to rise while liability values are capped. Our research shows that, for a sample pension scheme, the point where further inflation could be beneficial — otherwise known as the ‘tipping point’ — could occur when inflation reaches 1.2% above current market levels. Given the Bank of England has signalled that a rise in rates would undermine an already weak economy and curtail a much-needed rebalancing towards exports, this is not an unimaginable scenario.

The ‘tipping point’ will, of course, differ depending upon the specific nature of both the scheme’s benefit structure and its asset portfolio. It is therefore imperative that schemes understand exactly how their balance sheets are impacted by various inflation scenarios, particularly given today’s volatile economic environment.

Inflation impact may vary
Inflation affects pension scheme benefits in a number of ways. Firstly, each member’s benefits will typically increase annually — with the increase rate usually tied to inflation. UK law holds that pensions accrued after 1997 must increase every year after retirement by at least the rate of inflation up to 5%; for pensions accrued after April 2005, the cap on increases is 2.5%. The majority of deferred benefits also have RPI-linked increases, however here the total increase over the whole period is compared to using a fixed assumption of 5% per annum and the smaller of the two is used. There may also be those still accruing benefits or with pensions linked to national average earnings. These benefits are often seen as real in nature and therefore valued with reference to expected future inflation.

While realised inflation clearly affects the current level of benefits payable, future inflation expectations are just as important in determining the overall cost. The impact of a scheme on its sponsor’s balance sheet and cashflow is driven by valuations that allow for the projection of future pension increases, naturally incorporating inflation expectations. The higher these expectations, the higher the liabilities, deficits and subsequent contribution requirements.

On the other side of the balance sheet, schemes’ asset values may increase due to rising inflation expectations, but not always at the same rate as the liabilities. Assets such as index-linked bonds, inflation swaps, infrastructure investments and property with inflation-linked leases are linked to the RPI and therefore react directly to changes in inflation rates or expectations. Other assets such as equities and real estate investment trusts are also viewed as real in nature but, without a direct link to inflation, may react over a longer time period. Clearly, the impact of an increase in inflation on a scheme’s funding levels stems from the effect on both its assets and liabilities. This varies among schemes depending on the nature and maturity of their liabilities, the amount of real assets held and to what extent they are directly impacted by inflation.

Thanks to the explicit aim of monetary policy to keep inflation low and stable, inflation and inflation expectations have, until recently, remained under 5%, for example, below the cap levels associated with most pensions. Changes in inflation expectations have therefore fed through directly to liability values. For schemes not fully hedged against inflation, increases in asset values as a result of higher inflation have generally failed to match the increase in overall liability values, resulting in an overall deterioration in funding positions.

However, as inflation levels reach the 5% mark and the caps applying to most benefits have begun to bite, schemes are beginning to wonder at what point inflation increases will start to reduce deficits instead of increasing them.

Finding the ‘tipping point'
To illustrate the point at which inflation can positively impact a scheme’s portfolio, we can investigate the impact inflation increases may have on a real scheme. Consider a pension scheme with assets totalling £363 million and liabilities totalling £402 million — leaving it 90% funded. We can chart the impact of inflation increases across both sides of the balance sheet. The results from this analysis are highlighted in Table 1.

Table 1

The analysis shows that the example scheme, subjected to a 1% increase in inflation expectations, would see its liabilities increase by about 10%.  However, an increase from 2% above the current inflation curve to 3% would only increase the value of the liabilities by about 2% due to the protection afforded by the liability caps.

Turning to the other side of the balance sheet, we find that, as inflation expectations rise, so does the value of its index-linked assets and, as there are no caps on the inflation-linked cashflows from these assets, the values continue to increase above and beyond the corresponding increase in the liability values.

The result is that the scheme’s funding level initially falls as inflation expectations increase, and then recovers as expectations rise further. The point at which this recovery begins, or its ‘tipping point’, occurs when inflation rises start to improve the funding level. In this case the tipping point is around 1.2% above current market levels, so an inflation curve of approximately 5% per annum. This adds a key metric to the information for the scheme to consider when contemplating the impact of inflation.

The importance of understanding risk
As shown above, high inflation can reduce pension scheme deficits. However, the extent of this reduction depends on the nature of inflation changes and the make-up of the schemes’ assets and liabilities. Clearly, it is important for pension schemes to delve deeper into this issue and to understand their own individual risks from inflation in both the short and longer term.

In the past, pension schemes have been unable to stress-test the impact of changes in key risk factors — such as inflation — across the whole of their balance sheet. However, this is no longer the case. New technology provides DB schemes with the tools necessary to better understand the risks that they face and the potential impact on funding levels. By modelling both their assets and liabilities on a common platform, scheme sponsors and trustees are now able to stress-test both values under different inflation scenarios. This advance allows schemes to analyse the impact inflation might have on funding levels and determine the point at which further increases in inflation actually become beneficial, giving them a crucial advantage in managing and mitigating risk. When schemes are able to pinpoint the moment at which an increase in asset values outpaces their liabilities, they have found their ‘tipping point’.

Matthew Furniss is assistant vice-president at PensionsFirst