Richard Gibson looks at what deflation means for pension schemes.
- After a previous dip in April, figures for September show inflation has dipped into negative territory.
- While deflation is generally regarded as a bad thing, it isn’t necessarily the case for pension schemes.
- Most schemes set their pension increases based on inflation to September of the previous year. So the dip in inflation this month is important.
The UK flirted briefly with deflation in April, with the main measure of inflation negative for the first time since the Great Depression. Now figures for September by the Office for National Statistics (ONS) show that inflation as measured by the Consumer Prices Index (CPI) has once more dropped into negative territory.
What is deflation?
In short, deflation means that the general level of prices in the UK was slightly lower in September 2015 than it was in September 2014, based on the particular goods and services examined by the ONS.
Subtly, that is different to saying that the costs faced by a typical household have fallen. The actual costs faced by individual households will have varied more widely, depending on which of those goods they choose to spend more of their money on.
We usually hear that deflation is a bad thing. It reduces the ability of households, companies and the nation to service their debts and if deflation is anticipated over the longer term then consumers will delay spending, lowering the overall level of economic activity and leading to a spiral of further deflation and unemployment.
But this type of deflation is different - driven by a series of falls in oil and food prices - so being attributed to a price adjustment rather than what economists call more systemic demand-side effects.
So would a short period of deflation really be such bad news for pension schemes?
Deflation might affect DB pension schemes
Most deferred benefits are linked to CPI and there is generally enough leeway in cumulative past revaluation that short periods of deflation will be reflected in full in the pension eventually granted on retirement, resulting in lower pensions eventually being paid - in theory to reflect the lower cost of living.
For pensioners in payment, around half of all defined benefit (DB) pensions are still linked to inflation, perhaps subject to a maximum of 2.5% or 5% in one year, but importantly subject to a minimum of 0%. So lower inflation reduces a scheme's liabilities, but only so far. However, some pension schemes may contain a rule which allows them to offset a fall in inflation against the following year's increase.
Trustees should check their scheme's rules and consider the wording carefully.
If long-term inflation expectations are stable, there may be no change to assumptions about future inflation so a funding valuation would reflect only the immediate impact of the deflation on pension amounts without changing the longer-term picture.
On the other hand, when we look at the assets that schemes hold, any deflation in the Retail Prices Index (RPI) will feed through to index-linked gilts to reduce both the next and all future coupon payments.
If those bonds back pensions which cannot be reduced by deflation, the mismatch will cause a loss in a buy-and-hold hedge, not just a hit to the market value of the assets. That is even before considering any mismatch there may be between RPI assets and CPI liabilities.
Most schemes set their pension increases based on inflation to September of the previous year. So the dip in inflation this month is key. If inflation rises quickly as it is predicted to do, that may well pose a challenge in communicating to members next year why no increase is being given although inflation has by then become more buoyant.
Again, there is potential for a mismatch with index-linked gilts, who must measure their coupon payments based on RPI at a set point in time. Different bonds use different dates but the most important reference months coming up are in November and May next year - deflation in these months could especially hurt investors.
Both the Bank of England and the OBR anticipate that it could be some years before CPI inflation returns to its 2% target.
Warding off the threat of deflation
For trustees and sponsors looking to protect against the risks of deflation, there are difficulties in trying to construct too precise a hedging strategy for your liabilities - it is difficult to get away from timing and index mismatches without going all the way to an insured solution.
The cost of protecting or insuring against deflation risk is high. Recently this has made up about 3% to 4% of the cost of buying out pension liabilities with an insurance company, but this could be even higher if long-term low inflation expectations take hold.
But the real danger for schemes (and all of us) comes if inflation stays low for longer, which would mean poor returns for traditional growth asset classes and no end in sight to the low interest rate environment.
Richard Gibson is an actuary at Barnett Waddingham
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