29 July 2021

Worrying About Inflation’s Effect on Your Pension Finances? Don’t.

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Inflation can affect Defined Benefit (DB) plan finances, but the latest bout of it seems mostly favorable for plan sponsors, retirement industry experts say.

Brian Donohue, a partner at October Three Consulting, says that for inactive participants—or, for frozen plans, all participants—DB liabilities are fixed-dollar liabilities, so if inflation is high, the “real” value of their future pension payments declines. This decreases the purchasing power of the benefits participants eventually receive, but it makes the cost of liabilities less expensive for plan sponsors.

“It’s worth noting that, for most of this century, inflation has been very low, which is part of the reason pensions have been much more expensive to employers (and much more valuable to employees) than we would have guessed 20 years ago,” Donohue says.

Donohue notes that inflation has been less than 2% for the past two years on average, which is lower than expected.

“Everyone thinks inflation is bad, but part of the pain plan sponsors have suffered is because inflation has been lower than expected,” he explains. “They made benefit promises thinking that inflation would be higher, but, since it was not, it has been more expensive to cover those promises.” He adds that for sponsors of frozen DB plans, with fixed benefit liabilities, inflation would help them more than hurt.

Kevin McLaughlin, head of liability risk management, North America, at Insight Investment, says that with corporate DB plans, the majority of future liabilities are nominal, so there is no link with inflation. He notes that inflation could affect employee wages, however, which would affect benefit accruals.

For public DB plans, many offer cost-of-living adjustments (COLAs), and inflation would increase those payments. McLaughlin says this could be a bad thing if public plan assets were unable to keep up with inflation risk. “Many public pension plans are underfunded, so anything that increases liabilities but not assets is problematic,” he says.

How Inflation Affects DB Plan Investing 

On the DB plan asset side, higher inflation means higher interest rates, which is bad news for fixed-income investments, McLaughlin says. But corporate DB plans use fixed-income investments to match liabilities, so inflation will lower both fixed-income assets and liabilities.

However, inflation would not change the long duration fixed-income investments held in corporate DB plans.

“Corporate plans should keep hedges in place,” McLaughlin says. “If interest rates were to rise, it would mean corporate pensions will be better funded. The average hedge ratio is around 50%, so better funding means [pensions] could buy more liability matching, long duration fixed income.”

Donohue explains, “One way to think about hedging liabilities is that you’re out of the game and don’t really care about inflation or interest rates. If inflation is sustained, and your only goal is to stabilize pension finances and you’re invested in duration-matching bonds, what will happen is the value of bonds will go down and the value of liabilities will go down correspondingly.”

In the public sector, liability hedging is not as common, McLaughlin notes. He says public plans hold fixed income for diversification, and he would expect public plan sponsors that are worried about inflation’s effect on fixed income to keep the duration of their investments short.

 

McLaughlin says whether inflation is good or bad for equity investments depends on what is causing it: a demand hold or a cost push.

“The bad scenario for equities would be if there is an increase in cost but businesses can’t pass that on to customers,” he explains. “If costs rise faster than revenue, profits will decline. Higher inflation means lower multiples of future earnings.”

The impact of inflation is less clear for equity investments than for bonds or fixed-income investments, Donohue says. Some industries will benefit and others will be hurt. He says DB plan sponsors can trust their investment managers to watch the market and adjust equity investments accordingly.

Inflation doesn’t uniformly affect industries, Donohue notes. Bonds are a lot more homogeneous than stocks, so inflation overall is not a great thing because it makes managing equities more complex. However, he notes that most companies can handle modest inflation. “In the ’90s, we saw inflation of about 3% a year, but no one was talking about it,” he says.

McLaughlin says he believes the economy is seeing a more benign scenario now. “Although costs are increasing, companies have pricing power and can pass that on to customers,” he says. “It’s not true in all sectors, but generally speaking it is.”

Over a very long run, higher inflation will mean higher equity prices in general, McLaughlin adds. But, he says, Insight Investment’s view is that the inflation happening now is a temporary fluctuation caused by transitory changes.

“We still think inflation is contained over the long term,” he says. “The reason inflation risk is high is we are just reopening post-COVID-19, and there is stress in the supply chain. Inflation had declined a year ago because of COVID, but now it’s catching up.”

McLaughlin says that because Insight Investment is skeptical this is a long-term inflation trend, it is advising DB plan sponsor clients to stay the course for asset allocation purposes, although the firm understands why plan sponsors may have concerns.

“I do think that if plans are under-allocated to real assets and inflation-linked assets, they can look to allocate more to them as a hedge or diversifier,” he says. “They should look into government bonds that allocate to TIPS [Treasury inflation-protected securities], and if they have active equity managers, they can work with them to tilt portfolios toward firms with good pricing power, which generally won’t be adversely affected by inflation.”

“We’ve just had a little blip of inflation and if that’s all it is, in all likelihood it will have no effect on long-term interest rates,” Donohue says. “If we have a long run of inflation, the people in the business of lending money will decide they need to charge more, and ultimately that would change the rate used to measure pension liabilities.”

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