Kempen Outlook October 2017

Page 12

/// photo SHUTTERSTOCK

THE INFLUENCE OF INFLATION ON UK PENSION SCHEMES A defined benefit pension scheme’s liabilities are

scheme funding) they will typically never reduce

the Brexit referendum last year has pushed

linked to inflation and life expectancy. As these

benefits even if inflation is below 0 percent on an

inflation higher but still someway from the caps

variables increase the amount of money in cash

RPI (Retail Price Index) basis. We recognize here

most schemes have in place. Schemes had

terms that needs to be paid out in the future also

that there has been a ‘trend’ to move the

previously benefited from very low inflation that

increases. Current actuarial practice is then to

measure of inflation for many schemes from RPI

for most of 2015 was below 1.5 percent.

discount these cashflows using a rate dependent

to CPI (Consumer Price Index). Other things being

on gilt yields. As yields fall the net present value

equal, as CPI is typically lower than RPI this has

Increasing prices

of the cashflows increases.

a benefit to the funding status of a scheme.

We have so far concentrated on the impact inflation has on a schemes liabilities, inflation

It is therefore important for sponsors and trustees to have a thorough understanding of the

Liabilities

also impacts a schemes’ assets. Equity valua-

impact inflation can have on a scheme. Even

One of the worst things that can happen to a

tions typically increase as inflation rises. The

small differences in inflation, compounded over

pension fund in terms of solvency is deflation.

cause of inflation is increasing prices, as com-

long periods can cause large differences in total

Deflation, will typically decrease corporate

panies increase prices they can increase earn-

cashflows. If we assume stable inflation to be

earnings, decrease equity prices and decrease

ings and increase dividends thus resulting in

anywhere in the Bank of England (BoE)’s target

gilt yields. However the scheme is unable to

increasing valuations. The relationship is not

range of 1-3 percent this can still cause massive

decrease its liabilities – due to the floor on

perfect, and can break down at very high

changes in the amount of benefits to be paid.

inflationary increases promised to members. By

levels of inflation, but equities, nonetheless,

Outside of these ranges the impact can be more

contrast, very high inflation will have the oppo-

offer some protection against inflation.

complex and somewhat unexpected.

site effect with an increase in company earn-

Conventional government and corporate bonds

A typical schemes’ liabilities do not respond to

ings, equity prices and bond yields – the

however decrease in value as inflation

high or very low inflation in the same way they

scheme however will not suffer a large increase

increases. These instruments pay a fixed

do to moderate inflation. Most schemes set a cap

in liabilities due to the cap on inflation dis-

amount of cash every year and return a fixed

on the extent to which they will protect against

cussed earlier.

amount of capital at maturity. If inflation

inflation. For example, they will not inflate bene-

The inflationary environment at the moment has

increases unexpectedly the value of these

fits by more than 5 percent on an RPI basis. On

not been particularly favorable to pension

cashflows will be reduced and the price of the

the downside however (in terms of impact on

schemes. The fall in sterling we have seen since

bonds will fall to compensate.

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KEMPEN OUTLOOK, NOVEMBER 2017


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