Consquences of High Inflation for DB Schemes

Since the pandemic, inflation has reached record levels due to a combination of significant energy and commodity price inflation, strong demand and ongoing supply chain constraints.  Headline UK CPI reached 9.4% in June 2022, the highest level since inflation targets were introduced in 1992.  The expectation is that this will top 10% in October, remain above 9.0% for the rest of the year, before falling back to around 5% in 2023 and gradually returning to the 2% target over a number of years.

This has had significant impacts on pensions schemes;

Scheme funding:   Whilst the precise impact will vary depending upon the level of liability hedging and exposure to growth and credit markets, the increases in long-term gilt yields are equivalent to a fall in the value of a typical scheme’s liabilities of c 25%.  Schemes may, therefore, want to obtain an up to date funding position and review whether their long term funding strategy remains appropriate.  

Investment strategy: Significant increases in long term interest rates, have resulted in collateral calls as LDI managers seek to recapitalise these funds to maintain the level of hedging.  Schemes should consider whether they have sufficient liquid assets available to meet these collateral calls, which can take place at short notice.  Schemes may also want to review their overall strategy;

Maintaining return targets: meeting these collateral payments may require that growth assets be surrendered which might, in turn, impact on the overall return target.

Maintaining the target hedging level; with significant market movements, the effectiveness of the hedging can deteriorate quickly and become much less effective.  In such circumstances, Trustees should review whether their level of hedging remains appropriate which could also allow for the impact of any pension increase caps (e.g. 5%) and floors (e.g. 0%) and how likely these are to bite.  There could also be scope to increase your level of hedging as high long term interest rates have reduced the cost of obtaining this type of protection.

Employer covenant:  Schemes should assess any impact on their employer covenant from the current environment, in particular increased borrowing costs, high inflation and energy prices may push up costs with the employer then having limited ability to pass these onto customers in response.

Early Retirements and other factors:   Members who take early retirement have their pension reduced for early payment to reflect that their pensions will be in payment for longer.  Due to the way that these factors are typically calculated, members retiring early this year are likely to give up a high deferred revaluation increase in exchange for a materially lower pension increase in payment.  Schemes may want to discuss with their advisors whether it is appropriate to make an adjustment to the current factors and/or highlight the difference between revaluation and pension increases in the information they provide to members.

Other factors, including the transfer value basis, are less sensitive to short term inflation although Scheme may still want to discuss with their advisors whether they remain appropriate.

Member communications:  Scheme can expect to receive an increase in member queries as to how the current market volatility and high inflation impacts on their benefits.  In particular, inflation is likely to outstrip most fixed increases and any inflation caps meaning that pensions are less likely to keep pace with inflation.  This could result in increased queries and possible complaints as well as, potentially, calls to apply discretionary increases.

Sign up for smart, timely pension fuel and be the smartest person in the room. Delivered monthly.