Defined benefit (DB) pension schemes face an index-linked gilt (ILG) shortage of £500bn within a decade if deficits continue to close and the appetite for buyouts persists.
According to a report from Pension Insurance Corporation (PIC) and Fathom Consulting, the proportion of ILGs issued would need to increase from 25% to 75% over this period to meet demand.
This is based on the premise that economic growth continues to climb, company balance sheets look ever more solvent, and sponsors still seek to shift their pension liabilities onto an insurer.
A shortage of ILGs would drive up the cost of purchases, and while the government could remedy this by issuing more, this has its own consequences.
PIC head of strategic development David Collinson (pictured) explains: "If the government has a big deficit and a big debt, one of the ways to effectively reduce the size of that debt is to allow inflation to pick up while rates stay low.
"If you're only issuing fixed gilts then you'll benefit from that. If the government issues index-linked gilts, its ability to manage the deficit position by letting inflation creep up is more limited."
Still, the price of ILGs would rise if the government chose not to index more, hampering a recovery in funding positions because the gilts never return to their long-term level.
A call for more ILGs was already made earlier this year by the National Association of Pension Funds (NAPF) chairman Ruston Smith (PP Online, 6 March).
At the same time, LCP partner Charlie Finch highlights the rapid pace of demand for buy-ins and buyouts over the past three years, with the value of business written in 2014 reaching a ground breaking £12bn.
Although this demand has an upward pressure on prices, the Budget decision to abolish compulsory annuitisation has seen providers turn to the bulk annuity market, helping to create competition.
Finch says: "You need to get the timing right, otherwise you might pay more than you need to. But we're optimistic that there is a competitive market out there, and there certainly will be for the time being."
There are also alternatives to investing in ILGs, such as inflation swaps through liability-driven investing (LDI).
"There are a lot of funds out there now, even for some really small schemes, with pool formats so there are plenty of options along those lines. While yields remain low this makes it relatively expensive to hedge," Finch says.
Other substitutes include inflation-linked corporate bonds and other inflation-linked assets, but these can carry extra risks that schemes would rather avoid.
Another option is to follow the lead of the TRW Pension Scheme and offer pensioners the choice of swapping from an inflation-linked promise to a fixed pension (PP Online, 27 November).
But Collinson points outs: "The trouble is you then get into the argument of whether members themselves are best-placed to judge whether they're better off with a fixed pension or an inflation-linked pension."
Ultimately, the answer hangs on whether the government or the pensions system takes on inflation risk in the future.
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