How the slump in oil prices is hitting schemes

The dramatic descent of oil prices in recent months – down to $47 on Friday from $115 in June last year – has brought respite for many UK and global consumers by driving down inflation.

For pension schemes, however, falling oil prices and the knock-on deflationary expectations could impact the safe-haven nature of bonds and create volatility across equity markets.

In fixed income, low inflation expectations have flattened out yields along the curve to all-time lows. The European Central Bank’s move yesterday to inject ¤60bn (£45bn) a month into the bond market was a dramatic attempt to stave off deflation.

Low inflation in the longer term is bad news for pension schemes, said Yoram Lustig, head of multi-asset investments at Axa Investment Managers.

“Low inflation won’t erode the value of liabilities, which will be a problem for defined benefit plans,” he said.

Low inflation won’t erode the value of liabilities, which will be a problem for defined benefit plans

Yoram Lustig, Axa IM

“The discount factor in present value calculations is based on the yields of long-term government bonds. The present value of your cash is higher so the value of your liabilities is higher.”

Lustig said he thought bonds were not as conservative an asset as when yields were at more normal levels.

“The bottom line is dropping oil prices are good for the bond market in the short to medium term, but bonds will face headwinds in the longer term when yields normalise,” he added.

Peter Martin, head of manager research at JLT Investment Consulting, said he thought in the current environment pension schemes could take advantage of the opportunities to hedge their liabilities.

“Hedging and breakevens in inflation have fallen considerably recently, [it is] not a consensus trade but more talk about inflation being cheaper to buy,” said Martin.

Martin said he thought inflation is where schemes are most systemically underhedged.

“Perhaps it’s an area to take liabilities off and then when nominal rates increase to add that back. The time to buy inflation hedging is when the Sun is shining and people aren’t worried about inflation,” he said.

In equity markets the impact of falling oil is more difficult to map, but is usually characterised by the redistribution of money from major oil producers to airlines and consumers, who have benefited from lower energy costs.

Wouter Sturkenboom, senior investment strategist at Russell Investments, said: “What isn’t clear is how this story will play out in the more nefarious part of the commodities cycle – when do the defaults come in and companies start folding?

“This is the part that’s keeping equity markets down, the general uncertainty associated with a big price fall.”