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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