How might negative inflation expectations impact the DB pension scheme system?

Inflation vs deflation

Deflation – that might be a word you have not heard for a long time.

With inflation reaching new highs in 2023 and central banks holding their rates higher for longer, it is not surprising that deflation isn’t at the forefront of your mind – we’ve all been looking at the other end of the inflation spectrum!

Given that pension payments are often at least partly linked to inflation, the recent period of rising inflation has come through to impact many pension schemes – something a lot of us have experienced first hand over the last year.

However, when we start taking a longer-term view, acknowledging the difference between current inflation levels and implied future inflation levels, we can see that deflation could actually pose a huge systemic risk to DB pension schemes.

Current inflation vs implied inflation

Current inflation metrics (eg CPI & RPI) are calculated using past data on the historic rise/fall in prices. Implied inflation looks at what inflation is expected to be in the future. It calculates this by looking at the difference in yield between nominal and real debt of the same maturity. If “the market” thinks inflation will be higher/lower then surely clever investors will buy/sell inflation-linked assets to adjust the market level accordingly.

In order to address the fact that pension scheme liabilities change with implied inflation, DB pension schemes tend to hold index-linked gilts in their asset portfolios. When implied inflation rises, the index-linked gilts rise in value too, hedging this increase in liability values.

Inflation caps and floors in liabilities

There is one unique characteristic of liabilities that we need to remember: many DB pension schemes have their inflationary increases in pension payments capped at 5% and halted at 0%.

As implied inflation nears or goes beyond 5%, the Scheme's liabilities tend to become less sensitive towards inflation, because they are capped at 5% and cannot increase any further. At this point, Schemes that hold index-linked gilts will likely be over-hedged on inflation, because the index-linked gilts they hold will continue to rise in value beyond an inflation level of 5%. This is something we have seen over the recent period.

DB Schemes in this position will start selling their index-linked gilts in order to bring their inflation hedging back to the desired levels. As Schemes begin to sell their index-linked gilts, there is a downward pressure on the price of index-linked gilts and implied inflation is brought down to normal levels.

Doesn't seem so bad after all, does it? It might even seem too efficient that the market corrects itself?

Let us not forget the prime culprit of this article - deflation.

The deflation spiral of doom!

The initial story of deflation is similar to the one we have seen above, but the climax is a rather vicious downward cycle. As implied inflation turns negative (implying deflation), since pension scheme liabilities often have inflation floors at 0%, they become over-hedged on inflation once again. Once again, to address this, these schemes would begin selling their index-linked gilts.

It is not just a single DB scheme that would do this.

In fact, it is not just even a small handful of pension schemes that would do this.

Now, this might be the perfect time to mention as to why we have termed deflation as a 'systemic risk'. We are talking about the vast majority of pension schemes being in this position – because a majority of pension schemes hold index-linked gilts and have at least some liability inflation floors in place. In fact, pension schemes are some of the largest holders of index-linked gilts in the UK.

So in a deflationary scenario, we are talking about a world where index-linked gilts are being sold in aggregate by pension schemes at very large volumes.

This has the impact of pushing implied inflation down even further. As implied inflation falls further, pension schemes become over-hedged on inflation once again… and so goes on the perpetual loop, potentially resulting in a downward spiral of deflation that would require the Bank of England to intervene.

This is a potential concern for at least four reasons:

1. As each scheme chases down prices on index-linked gilts, individual schemes will be constantly locking-in losses?
2. Will schemes be able to put hedges back-on quickly enough if/when markets stabilise?
3. Is there a natural buyer of index-linked gilts to stabilise the market?
4. How helpful is it for the UK government if investors will only pay a low price for newly issued index-linked gilts?

Surely deflation isn’t going to happen, right?

As central banks are still fighting to get current inflation under control, you might wonder if I am being overly precautious by talking about all this now. However, I would like to remind you once more that it is not the current inflation that is of significance, but the future implied inflation.

So, when should I start thinking about them? It may make sense to start focussing on this when implied inflation falls below 2.5%. At a 2.5% level of inflation, pension schemes are furthest away from hitting their caps and floors and so are at their most sensitive to inflation.

Above is a chart from Visualise, our in-house financial modelling tool, that shows the BEI stretching 50 years in the future. We also see it nearing dipping below 3% towards the end of the chart.

Impact on leveraged funds

The climax of the deflation induced gilts sell-off might seem too much like a déjà vu to you, and you would be right. The effects of a deflation induced index-linked gilt sell off holds very close resemblance to the sell offs we saw during the 2022 gilt market crisis. This is not just because we are talking about a gilt market spiral, but because of another feature of pension funds that could exacerbate the crisis: the use of leveraged LDI funds.

Once we acknowledge that many pension schemes hold their index-linked gilts via leveraged LDI funds, this vicious downward deflation cycle looks even more dangerous.

As the value of the leveraged exposure to index-linked gilts fall, so too does the value of the Scheme's holdings in a leveraged LDI mandate, which pushes the leverage level within the LDI mandate up. When the value of the leveraged LDI fund falls below a set level, LDI managers generally start calling for collateral – additional monies from the pension scheme to bring down the leverage to a more comfortable level.

To meet these collateral calls (which often have fairly short timeframes) pension schemes would likely have to sell their other assets, maybe at a less than desired price to meet these collateral calls. Selling assets at an unattractive price can then have a knock-on impact on a scheme’s funding level.

Where schemes are not able to meet their collateral calls, LDI managers will likely have to reduce the level of hedging significantly by selling off the index-linked gilt holdings within the LDI mandate.

A question that might naturally rise is, what’s the problem with this? Why can’t the pension scheme just sell off its index-linked gilt holdings if they start to notice this downward spiral? After all – we were talking about selling off some index-linked gilt holdings earlier, to avoid over hedging.

There are a couple of points to this answer:

• The DB Scheme will still have inflation linkage in their liabilities, even when there are floors in place. They will likely not want to sell too much of their index-linked gilt holdings, as this will mean they end up significantly underhedged on inflation. If an LDI manager automatically cuts the level of inflation hedging by selling off index-linked gilts, this could be a much greater reduction in inflation hedging than required.
• What if implied inflation goes up again? Pension schemes have long time horizons, and it is likely that implied inflation will rise once again, and thereby pension schemes will want to increase their hedging by buying more index-linked gilts. It’s important to think about this prospect early on, so a scheme avoids selling index-linked gilts when they are low in value and buying them when they are more expensive.

The threat of a deflation spiral is therefore a systemic risk that pension schemes should think of carefully, with forward planning.

What can be done?

Unfortunately, as with most systemic risks, there is no easy answer. Broadly speaking, there are two main options available to pension schemes.

• Approach 1: follow the market and sell index-linked gilts (the sooner the better) in order to reduce hedging to desired levels. Better to be at the front of the queue under this strategy.
• Approach 2: “ride out” the sell off wave, and perhaps even look to add to inflation hedges when prices are cheap. There’s an argument to suggest inflation rarely does actually remain negative for long periods of time. I might suggest in order to do that these schemes might ideally have one of the following in place:
  • A contingency plan in case deflation actually occurs.
  • Have sufficient collateral, in the form of liquid assets, to meet the collateral calls from the managers in a potential stressed market event.

You could even argue there is a “something in between” approach, whereby inflation hedges are quickly rebalanced when inflation expectations rise (after all, it locks in gains) but you take your time and ride out market volatility when inflation falls (avoiding locking-in losses for short-term market gyrations).

Hopefully I haven’t scared you off to much by this blog, but instead have you convinced you that this is the right time to start thinking about deflation risk and making contingency plans that might come in handy!

Get in touch with us to discuss this further. After all, hedging inflation is supposed to reduce risks, not add risks.