Natasha Browne examines the likelihood of negative inflation and the consequences for pension schemes.
The UK experienced a bout of deflation in 2009 when the retail prices index (RPI) fell into negative territory. The index recovered quite quickly, however, and pension schemes were largely unaffected.
But deflation as measured by the consumer prices index (CPI) has never happened. That could change after it hit a record low of 0.3% in January, however. The fall was driven by the reduction in oil prices, which have halved in the past six months.
The Bank of England governor Mark Carney expects CPI to turn negative for a brief period in the spring. Delivering the bank's inflation report on 12 February, he also opened up the question of cutting interest rates further, possibly to below zero, if the downward slide in inflation worsened materially.
From a pension scheme perspective, subdued inflation can provide a boost to funding levels. The inflation-linked rises in pensions in payment are reduced, easing the pressure on schemes. But pensions in payment cannot be decreased, even if deflation kicks in.
Barnett Waddingham partner Matt Tickle says well-hedged schemes could be hurt by deflation. He explains: "Where schemes have taken out inflation hedging through index-linked gilts or through swaps or whatever it might be, there's no zero bound on those. So there's no zero floor on the assets but there is on the liabilities so you start to get that mismatch coming through."
Senior portfolio manager at Axa Investment Managers (Axa IM) David Dyer says schemes should have a mixture of fixed income and inflation-linked assets to help manage inflation movements. "They have to do that to allow for the fact that pensions won't always go up in line with inflation; it's limited both on the downside and upside," he says.
Links to CPI or RPI
Local government pension schemes (LGPS) are typically linked to CPI so the movements in this index are particularly relevant to them. But many schemes are still linked to RPI, even though the Institute for Fiscal Studies called for it to be axed as an inflation measure last month. Still, the distinction between CPI and RPI linking is not clear cut, as Towers Watson senior consultant Martin Faulkner points out.
"For many schemes, the link will be stronger to CPI prior to retirement rather than after retirement. After retirement is very much dependent on the way the scheme rules were written. Pre-retirement tends to be more following statute," he explains.
For schemes following statute, payments would not be reduced in a single year if inflation turned negative. But there is a question over whether the scheme rules would allow trustees to offset this against higher-than-expected inflation increases in future. Faulkner says: "I suspect that would be quite a tough call for many trustees to actually make even where the rules allow it."
Deflation of -0.5% would see schemes effectively pay £100m in excess of inflation for pensions in payment, says Calum Cooper, a partner at Hymans Robertson. This is based on a £20bn private sector annual pay-out.
Cooper says: "In an extreme and unexpected situation where you have prolonged deflation, like we had in Japan in the late 90s and 2000s, if that were to become entrenched, which I think is unlikely, alongside sluggish growth and recession, then that would start to have a significant impact."
Negative interest rates
It is this type of dismal scenario that would cause the Bank of England to cut rates. Tickle thinks the bank may have been emboldened by events in Europe too. Switzerland, Denmark and Sweden have all taken the decision to turn interest rates negative.
But he adds: "I think it's far more likely that the next move is up rather than down by an incredible factor. The bank has said it's quite keen to raise rates to give it the freedom to actually reduce rates if things get worse in the future."
Towers Watson senior economist Jonathan Gardner agrees, adding: "You would really only foresee it happening if some kind of crisis in the eurozone permeated out and put a negative shock onto the UK. I would suggest it's still less likely than a rate rise but the last inflation report did open the door to it if there was a negative shock in Europe."
Faulkner also explains that negative interest rates would have a muted effect on pension schemes in the short term. "Whilst it may adjust the short end of the yield curve, there would be an open question about any longer-term effect. If it were the case that yields fell across the whole curve, one would expect to see an adverse implication for many schemes. But not all, because some will obviously be better hedged against that type of movement than others."
Although negative CPI is looming, the downward pressure on inflation is primarily due to the one-off effect of low oil prices. Tickle is upbeat about the longer-term impact. He says: "If it actually creates a bit more growth in the medium term and entices consumers to spend that extra money they've got in their pockets, it could create a bit more inflation next year than we'd have otherwise seen."
The Bank of England's next inflation report is due on 24 March.