Shajahan Alam says giving DB schemes flexibility to reduce inflation linkage sounds a lot simpler than it would be in practice.
On 30 September it was reported that the parliamentary Work and Pensions Committee (WPC) would consider allowing defined benefit (DB) private sector pension schemes to cut costs by suspending inflation increases in order to ease the growing pressure of funding deficits.
However, its chairman Frank Field MP did not mention breaking the inflation linkage in pension schemes specifically. Despite this, the report prompted a reaction in markets during the late afternoon. For example, the 2068 index-linked gilt yield moved over 15 basis points (bps) higher within a few minutes and 30 year inflation swaps prices fell around 8bps before recovering slightly. The reaction to this news has led to the market pricing in less demand for these assets.
Recent issues around the British Home Stores and British Steel pension funds have shaped the scope of the WPC's ongoing inquiry, which is considering all options. It could be argued therefore that there was nothing new in Mr Field's comments. Indeed markets have since retraced much of Friday's move.
Whether or not the market reaction on 30 September was overdone, there is merit in considering the likelihood and the possible details of radical changes. In our view, giving schemes the flexibility to reduce inflation-linkage in some way sounds simpler than it will be to implement in practice. It is fraught with difficulties. We can take a look at the complexity facing this inquiry by asking some basic questions.
What inflation linkages will be affected?
Schemes could be allowed to take away inflation linkage to current pensioners only, or flexibility on this front could extend to future pensioners once their benefits come into payment. Or indeed it could also be permissible for inflation-linked increases that apply prior to retirement on deferred member benefits to be taken away.
While all of these scenarios would result in different levels of impact on the demand for inflation-linked assets, the implications would be non-trivial in all cases.
All of these options risk resistance from important segments of the population. At the heart is the issue of allowing UK plc to renege on promised benefits. Broad consensus would be required to implement anything radical and it would be needed in advance of any political will to do so. While making the intergenerational trade-offs implied by DB pension schemes fairer for the younger generation provides a strong theoretical argument to impose radical changes, pragmatic political calculus tends not to support the case.
Another, less radical option would be to allow schemes more flexibility to move indexation from the Retail Price Index to the (lower) Consumer Price Index measure of inflation. This option at least has the benefit of being aligned to what has already been imposed to public sector schemes (although again this would have legal complexities given the benefit linkages set out in specific scheme rules).
Which schemes and employers would be given the flexibility?
While ostensibly the inquiry is reviewing the private sector DB industry as a whole, the red lines in the industry may well limit what can be implemented in practice. This goes back to reneging on past promises.
Historically DB schemes were discretionary vehicles, providing pension increases when it was deemed they could afford them. Having turned these into concrete promises over the last 30 years or so through legislation - albeit for good reasons - allowing flexibility to all schemes would be a massive reversal of this trend.
The more likely outcome is that any flexibilities, whatever they may be, would be granted only to schemes and/or scheme sponsors that are ‘in trouble'. What tests are to apply for a scheme/sponsor to be eligible will need to be detailed. Here, the behaviour of sponsors and trustees could be influenced by what flexibilities could potentially be applied versus what benefits the Pension Protection Fund provides.
To summarise, there are a lot of uncertainties around this inquiry, and given the potential for radical changes - albeit with small probability - this could continue to be a source of ongoing market volatility. And it's a reason for trustees and sponsors to delay hedging and pouring money into schemes that could end up having a lower deficit than they assume now.
Shajahan Alam is head of research at AXA Investment Management
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