Deflation and your DB Scheme

In addition to various sporting celebrities, now unemployed Top Gear presenters and several car manufacturers, I also “follow” a few notable people on Twitter, one of which is the Chancellor of the Exchequer, George Osborne. On the date of writing this blog, George Osborne tweeted “Our plan for working people gets another boost today with good news for family budgets – Inflation at zero for a second month in a row”. Remembering that this is election time and politicians are doing everything possible to endear themselves to the public (roll out the usual baby photos and visits to schools), the first half of this tweet has been written to do exactly this. I do however have some scepticism about inflationary figures being quoted as it is unlikely that my unique “basket of goods” will stack up with those components which are used to determine CPI.  (It would be quite an achievement if it did, as most of the time I don’t know what I am going to put in my shopping trolley until I am walking up and down the various isles of my chosen supermarket!) This sentiment was echoed in a recent review of the consumer prices statistics carried out by Paul Johnson of the Institute for Fiscal Studies for the UK Statistics Authority. Johnson’s report observed that inflation can mean different things to different people, and as such, choosing a personal measure of inflation can be very difficult. While the majority trustee’s of pension schemes have the benefit of the measure of inflation being specified in the scheme rules, I will be considering the measure which George Osborne tweeted about – the Consumer Prices Index (“CPI”) – and what impact deflation could have on occupational pension schemes. In its February 2015 Inflation Report, the Bank of England stated that “CPI inflation is likely to fall further in the near term and could briefly turn negative as energy and food price inflation continues to weigh on the headline rate”.  The main concern with deflation is that consumers will put off purchasing items today, for fear that they will be available at a reduced price tomorrow. (Think DFS and their sofa sales – you would have to be hugely unlucky to have bought your sofa at full price given their frequent and persistent sales.) As such, a reduction in consumer spending would lead to reduced economic activity. This could significantly impact pension schemes because reduced consumer spending leads to lower corporate profitability, which, in turn, leads to lower yields on issued investments (eg. dividend yields on equities). This alone is a contributor to the inability of sponsor’s of DB pension scheme to support their Recovery Plans. Consequently, any decrease in spending could therefore widen the gap between a pension scheme’s assets and liabilities. The following sets out other ways in which low inflation could impact pension schemes according to the 3 categories of membership in a defined benefit pension scheme. Active Members As part of an actuarial valuation, one of the necessary assumptions is a pensionable salary growth assumption. This may be of the form “CPI + 1% p.a.”, therefore if CPI were to decrease and become negative, a member’s final pensionable salary would not increase (as in practicality, a floor of 0% p.a. will be applied). However, different schemes will have different pensionable salary definitions, for example there may be some degree of averaging or indexation over a previous period, therefore the impact of deflation on an active member will be dictated by the scheme rules. Deferred Members Different sections/tranches of a deferred member’s pension will increase at different rates. Their Guaranteed Minimum Pension (“GMP”) will revalue at a rate which is determined by the date they left the scheme, where as their excess pension will usually increase in line with CPI. Past practice has indicated that periods of deflation have been absorbed by the scheme and a deferred member’s pension was not reduced. Consequently the impact of deflation on deferred member’s could be limited in the case of a short period of deflation. Pensioners in Payment The impact on current pensioners or dependants will depend on the scheme rules and the rates at which different tranches of benefits increase. Under current legislation, pension schemes cannot reduce pensions in payment in times of deflation, therefore again; its impact would be limited. Cause for Concern In an attempt to ward off deflation and boost the economy, Quantitative Easing (“QE”) is frequently used by Central Banks. The theory here is that buying long term assets like government bonds (“gilt”) to drive up their prices and bring down their yields. This creates a low interest rate environment which induces firms and individuals to consume more and help the Central Bank to reach their target rate of inflation. In theory. However, for DB schemes, by suppressing gilt yields, which many pension schemes base their discount rates on, lower discount rates will lead to higher liabilities. (As a rule of thumb, a 1% change in the net discount rate could change liabilities by up to 15%). Over the last 4 years, QE has been a significant contributor in causing pension scheme deficits to increase substantially. Protection against deflation Schemes often choose to hedge/reduce inflation risk by purchasing assets which reflect the nature/term/currency/uncertainty of the liabilities. This is known as asset-liability matching. A common approach is to purchase index-linked gilts to match the liabilities for pensions in payment. The problem however is that in a period of deflation, the value of these gilts can decrease, but as explained above, the value of the pension will remain the same, leading to increased costs for the sponsoring employer. Many investors in the Eurozone are even willing to accept negative yields on investments, as they fear that yields could become even more negative in the future. For example, on Wednesday 8^th April 2015, Switzerland became the first government in history to sell benchmark 10 year debt at a negative interest rate (-0.055% p.a.). Quantitative easing and deflation fears have pushed up bond prices to the extent that the Swiss government was able to auction 10-year debt at a negative yield, therefore effectively charging investors for lending money to the government. In addition Germany, Austria, Finland and Spain have all sold shorter-term debt at sub-zero yields. Other hedging techniques include pensioner buy-ins, purchasing inflation swaps or developing a bespoke investment strategy to protect against inflation. These options may not be available to all schemes due to the associated costs, therefore pooled Liability Driven Investing (“LDI”) funds may be worth considering. How likely is persistent deflation in the UK? Contrary to the Eurozone, the UK continues to be regarded as a “safe haven” for investors. The best indicator to demonstrate this is to look at the market implied rate of inflation for the long term (15 years). As of today, the market is pricing inflation to be approximately 3% over the next 15 years; therefore while there may be short stints of deflation, the market is not suggesting this will persist. As such, when you consider that the State pension and DB pensions have valuable inflation protection built into them, it is worth ensuring that members maximise entitlement for the former, and carefully consider exercising options (such as forgoing inflation linked increases for higher flat pensions) for the latter.