Schemes need to understand exactly how their funding positions are impacted by various inflation scenarios, argues PensionsFirst's Matthew Furniss
With the latest statistics showing inflation is becoming more and more unpredictable, it is clear that defined benefit (DB) pension schemes need to understand their individual risks from inflation across both sides of the balance sheet, and in both the short and long term.
Only then can they be in a position to chart a path for their portfolio in a wide range of scenarios, increasing their capacity to manage market risk.
And in a dynamic and evolving economic environment subject to volatility, such effective risk management is crucial in enabling pension schemes to navigate a wide range of market conditions.
Conventional wisdom, of course, suggests that increases in inflation expectations should have a negative impact on funding levels – as schemes face increased benefit pay-outs to members that are not matched by increases in asset values.
Yet schemes that delve deeper into the issue by stress-testing both their assets and liabilities under different inflation scenarios may find that this doesn’t always hold true.
Since the early 1990s inflation levels have remained below the pension benefit cap levels associated with most pensions and increases in liabilities as a result of higher inflation have not been matched by increases in overall asset values. Inflation increases to date have therefore worsened funding positions for pension schemes.
Yet, given the latest ONS figures, we are now not far away from a point at which increases in inflation expectations should start to reduce rather than increase deficits.
Indeed, latest PensionsFirst research highlights that in the case of the FTSE 100, increases in inflation are costly for schemes only up to a level of, on average, 1.4% above the current expected market rates.
So an inflation curve of approximately 5.2% annual inflationary increases beyond this level – the so-called “tipping point” – should result in improved funding levels, as caps on pension increases to members come into play yet asset values will continue to rise.
On an individual scheme basis, such detailed information on their own scheme’s tipping point can be invaluable to sponsors and trustees of DB schemes – enriching decisions on investment strategies and de-risking activities.
Given individual “tipping points” differ depending upon the specific nature of both the scheme’s benefit structure and its asset portfolio it is imperative that schemes understand exactly how their balance sheets are impacted by various inflation scenarios, particularly in today’s volatile economic environment.
To do this, however, necessitates schemes having the infrastructure in place to be able to measure their assets, liabilities and risk exposure both accurately and on a timely basis.
Under the traditional structure of triennial valuations this was simply not feasible. But, as was discussed extensively at the Endgame conference earlier this month, there is an answer and it comes in the form of technology.
Video: Timothy Lyons, CEO of PensionsFirst, talks to David Rowley about measuring and managing pension fund risk.
Pension business intelligence platforms provide DB schemes with the tools necessary to better understand the risks that they face and the potential impact on funding levels.
By modelling both their assets and liabilities on a common platform, scheme sponsors and trustees are therefore able to stress test both values under different inflation scenarios.
This advance allows schemes to analyse the impact inflation might have on funding levels and determine the point at which further increases in inflation actually become beneficial to their scheme, giving them a crucial advantage in managing and mitigating risk.
When schemes are able to pinpoint the moment at which an increase in asset values outpaces their liabilities, they have found their “tipping point”.
And in today’s increasingly volatile economic environment, such accurate analysis and forward planning is not only beneficial, it is essential.
Matthew Furniss is an assistant vice-president at PensionsFirst.
