Will inflation knock your scheme’s endgame strategy off track?

This is put to the test in volatile market conditions such as the current high levels of inflation we are currently experiencing. 

Whether this could put endgame strategies at risk will largely depend on how effectively company and trustee governance frameworks work in practice.  

So, what risks does high inflation pose and how should schemes be responding?

What are the risks?

Inflation has increased significantly over the past year and reached the highest level in decades at the start of 2022.  

There is significant uncertainty on how long current inflationary pressures will last and these may persist materially longer than central economic projections predict. It is therefore important that schemes plan accordingly for multiple inflationary scenarios.

High levels of inflation can change the behaviour of scheme liabilities, specifically benefits linked to inflation with caps.  

For example, a pension benefit with annual inflationary increases capped at 5 per cent will have, until recently, acted as an inflation-linked benefit for hedging purposes. However, at current inflation levels the benefit will be acting more like a fixed liability.  

This illustrates the need for schemes to revisit their hedging strategy to ensure it is performing as expected, with protection assets closely matching the scheme liabilities.  

More fundamentally, the new inflation environment means it will be appropriate for schemes to review whether their current levels of hedging remain fit for purpose.

The current level of inflation will also have wider implications for scheme investments. Traditional asset classes that provide a measure of inflation protection, such as index-linked gilts, could look expensive in current market conditions.  

There are alternative asset classes that provide a degree of inflation protection, but how will these fit with the current investment and endgame strategies?

Many individuals will be facing financial hardship in the current economic climate, and this may create a new dynamic for schemes that offer certain forms of discretionary benefits such as pension increases in payment.  

However, the awarding of such increases comes at cost. These risk areas have in common:

• Complex issues that require careful analysis and consideration.
• Time-sensitive decision-making.
• The potential to materially knock an endgame strategy off track if not well managed.

The challenges created by current inflationary pressures is a great example of where good governance can make all the difference.

Stay in control

Schemes with effective endgame strategies have robust governance frameworks in place that will enable these issues to be picked up quickly and promptly addressed.  

The key features of an effective governance framework include:

• rapid identification of the issue;
• a mechanism for the trustees and company to discuss and agree a way forward;
• timely implementation of any changes.

Approaches such as joint pension forums can be excellent conduits for these discussions.

The challenges created by this situation highlight another important principle of keeping an endgame strategy on track — it is often better to take pragmatic action in a timely fashion than wait too long for a perfect way forward.  

When discussing the implications of current inflation levels, different advisers will have different economic models and varying views on optimal actions to be taken.  

The risk of inaction by getting locked into a technical debate needs to be avoided.

Overall, it is vital that the trustees and the company work together to stay focused on the bigger picture endgame strategy, and work with all advisers to find common ground steps that can be taken quickly to maximise the chance of keeping the strategy on track.

Leonard Bowman is head of corporate DB endgame strategy at Hymans Robertson