There has been much debate around the cost of living crisis, fuelled by recent inflation increases. These short-term rates are defined by the rising cost of goods and services, as measured over a rolling twelve-month period, and have been driven by the soaring costs of energy, food and consumer goods. The emergence from lockdown, changing consumer demand dynamics and the Ukraine crisis have led to a sustained period of higher prices and short-term inflation. There is an expectation that inflation will begin to fall in 2023, due to the short-term nature of measurement, it remains to be seen how embedded price rises will become?
The question as to how or whether this short-term inflation will ultimately impact longer-term inflation expectations is complex, but should inflation not be transitory, longer-term inflation expectations could begin to rise, impacting pension scheme funding.
Given this uncertainty, trustees should consider how robust their pension scheme is, in a more heightened and sustained, period of inflation. Do traditional assets, particularly within the growth portfolio, behave well in an inflationary environment? Given, likely changes to scheme funding levels, revisiting strategy and the assets used to drive returns remains sensible.
Given the recent, well-published problems many pension schemes have faced within the matching portfolio and leveraged matching products; the question around the level and type of liability hedging employed comes into play – the question now is, if not fully protected, how and when to make that change and if doing so, how to structure the solution in a sensible manner with the consideration as to how much leverage to employ? As many have experienced, mandates need to remain liquid to facilitate cash generation for capital calls from leveraged liability matching products. This has shown to be hugely important following recent market events. When considering solutions to use, if increased asset volatility should persist, the quantum, timing and speed of cash generation from all asset types becomes all the more important and should factor into any decisions being made.
Short-term inflation expectations by definition are short-term in nature. Longer-term inflation expectations are the rate at which the market expects prices to rise over the longer-term. Given the longer-term nature of pension scheme liabilities, any increased movement in longer-term expectations can have a material impact on the value of pension benefits. Many schemes have protected themselves with inflationary benefit caps, but for these to bite, inflation expectations would need to increase significantly, and there is little expectation of this happening just yet.
The Bank of England continues to target longer-term inflation of around 2%, and whilst it expects the current rate of inflation to fall; it will likely remain above this target for some time. As we have seen, the Bank continues to increase interest rates in an effort to control inflation but runs the risk of increasing rates too quickly which could result in a sustained period of recession, and they are clearly mindful of this. At the same time, the Bank has needed to intervene in providing market stability following recent elevated gilt yields and the focus has been taken away from actions to control rising inflation.
As a result, heighted short-term inflation (albeit more subdued once recent price shocks have fallen away) is likely to be around for a while yet and whilst there is some risk to higher longer-term inflation expectations, with continued Bank intervention, these may well be controlled. The Bank, however, has commented that it has limited levers to pull, and the blunt tool of interest rate hikes take some time to work.
Trustees should therefore “kick the tyres” of their investment strategy to ensure that it remains fit for purpose, know the risks involved and where the scheme is exposed taking corrective action if necessary; to ultimately ensure that the wheels of the strategy don’t fall off, as the short term journey is likely to get that little bit bumpier in the coming months.
