Inflation is back and it is posing challenges to pension schemes, including to the value of benefits, assets and liabilities. And, for trustees, there is one particularly hot topic: the price of protection.
Getting inflation under control will not be easy for policymakers, given the extent of pressures on food and energy, but it must be done as real incomes continue to decline. Interest rates have already risen and look set to increase further. Central bankers tasked with hitting inflation targets have little choice but to raise rates, even though growth is slowing sharply. Any other course of action risks entrenching higher inflation expectations and prolonging the pain.
With economic growth stalling, stagflation is a threat that trustees need to consider seriously. Many of us will not have faced this risk in our working lives, and it is essential that trustees prepare for an extended period of increased market volatility, rather than assume a quick return to a benign environment of rising asset prices.
Stagflation, should it materialise, threatens the investment returns of growth assets. Equities may be a better inflation hedge than bonds, but dividends do not provide a guaranteed income and profit assumptions need to be reassessed. Schemes may find that their target returns are harder to hit in the next few years. Those with larger allocations towards return-seeking assets could discover that funding levels do not improve as interest rates rise, contrary to the prevailing wisdom when funding plans were set.
This year's rise in bond yields has triggered collateral calls on liability-driven investment (LDI) hedges in what has been the biggest test for these strategies to date. Some schemes have struggled with second round effects such as replenishing collateral and asset allocation being out of line with strategic targets. The need to revalue liabilities that may have changed meaningfully due to inflation should not be forgotten either.
On the whole, however, schemes have been well prepared for these collateral calls, with most LDI hedging strategies coping well so far, through a 1.5% increase in real yields. But this doesn't guarantee they will be fine if real yields rise another 1.5%. In the first half of this year, many schemes sourced collateral from the lowest hanging fruit, the most liquid assets. Not all of this has been replenished. Trustees need to consider whether collateral waterfalls are strong enough to withstand a similar further rise in yields and if governance arrangements are sufficiently flexible to respond to renewed large cash calls.
Schemes have tended to focus on maintaining their LDI hedges at all costs. For most schemes, this will be right. But not for all. Trustees and sponsors need to carefully consider the opportunity cost of maintaining the hedge. In certain cases, perhaps where schemes are over-funded or are still significantly under-hedged versus target, a case could be made for allowing a reduction in the hedge of say 5-10% rather than selling assets at unfavourable levels or moving away from a scheme's target strategic asset allocation. Alternative levers that could be pulled include replacing physical assets with synthetics to maintain exposure or considering pre-payment of contributions to void drawdown (this may be attractive for an overseas sponsor given the current weakness of Sterling).
In the world of pensions, one size does not fit all. Trustees need to take a tailored approach for their own schemes, with advanced preparation key to enabling timely responses when markets move. Preparations should involve scenario planning and a consideration of options to mitigate risk, and these should be regularly reviewed and updated.
As we know, it is rare that markets will move exactly like a pre-prepared scenario. But good planning enables us to understand best and worst case outcomes, and plausible variations between these extremes. Trustees can get a feel for how the scheme will fare under different circumstances, helping them make decisions more confidently in high-pressure situations, for example if bond yields rise rapidly again.
Pension schemes are better funded and better hedged than they used to be, but we should not be complacent. Effective planning and communication between trustees, advisors, asset managers and sponsor companies can ensure that schemes are prepared for any bumps in the road that lie ahead.
David Brickman is a director at Independent Trustee Services