Dealing with inflation
IPE asked three pension funds - in Austria, Finland and the Netherlands - the same question: ‘How do you protect your investments from inflation?’ Here are their answers:
Jeroen Steenvoorden, director at SPMS, the Dutch pension fund for self-employed medical specialists, which has AUM of €5bn
We started our pension fund in the 1970s, at a time when inflation was a huge problem. Consequently we have always had a relatively large focus on inflation, which makes us unique among the Dutch pension funds.
Dutch inflation is lower than European inflation at the moment and our central planning bureau expects inflation of only 3% for this year. This means that currently SPMS is not directly affected by rising inflation because - due to our yearly minimum indexation guarantee of 3% - we have to take into account a 3% increase of our pensions when calculating our technical reserves.
However, in reality we look to civil servants’ salary increases as a benchmark for our conditional ambition. And recent agreements between trade unions and the government led to an increase of above 3%. Given our 3% guarantee, low inflation is far more favourable for our members.
But we are prepared for higher inflation as we currently have a higher indexation capacity than 3% and are currently protected by natural hedges, such as investments in shares and alternatives, notably funds of hedge funds, global tactical asset allocation funds and real estate. Currently 12% of our assets are invested in real estate, with the strategic allocation being at 15%. We also benefit from the mismatch of our assets and liabilities, in other words not all of our interest rate risks are covered. Because, in normal circumstances, if inflation is going to rise, interest rates will also rise, offering partial protection against higher inflation.
But as periods of high inflation and stagflation are possible over the long run we, as long-term investors, are also investigating the impact of inflation swaps on these scenarios in our new ALM study.
So far, few pension funds have hedged their inflation rate risk with inflation swaps but more are looking at them nowadays. Due to solvency requirements, the focus in the past was on the risk presented by falling interest rates rather than inflation. But it is growing in importance now.
Over the short-term - given the current asset allocation - there is limited room for tactical policy manoeuvre at times of rising inflation and, according to your market vision, you can over or underweight certain asset classes. And so for us the impact of inflation over a 15 to 25-year horizon is most important. But changing long-term inflation expectations could possibly alter the strategic asset allocation.
Dutch regulations have set no direct restrictions with regard to dealing with inflation. But indirectly pension funds have to take into account their conditional indexation or wage increase ambitions in their cost-price calculations for their premiums. If the long-term expectations are based on rising inflation, the premiums have to rise. With its focus on short-term solvency risks, the new financial framework has forced some pension funds with a lower coverage ratio to hedge their interest rate risk, which means they have become more sensitive to higher inflation. However, if inflation stays at the European Central Bank’s target of 2% this should in general not be a problem.
Christian Böhm, CEO at APK Pensionskasse, which has AUM of €2.5bn
Because we mainly administer DC plans, the risk of rising inflation lies with our beneficiaries and it will be more or less impossible in 2008 to increase the pension payments in line with inflation rates. We also believe that inflation is currently only high in specific areas such as commodities and that the levels will come down again.
But of course inflation presents a risk to our assets and that is why we are carefully watching our bond portfolio and interest rates. But despite a higher than usual cash rate under a flat yield curve, we are not going to overreact, as the higher cash rate is a result of increasing short-term interest rates.
We invest in real estate and commodities only to a limited extent - and at a very low level for commodities - but not purely for inflation benefits. Other factors must be taken into consideration too. And we are careful with these investments as certain property markets are overheated due to the fact that many people have been driven to property by the fear of inflation. So it is better to look at a fundamental evaluation in every asset class.
By investing in real assets, such as certain stocks, we will automatically gain some inflation protection if the companies are able to increase prices. We still need to look at the duration levels of these stocks, as there may be a trade-off between interest rate levels and stock prices if interest rates go up. But over the long-term stocks - and also property if you buy it at a reasonable price - provide some protection against inflation.
If you are well-diversified around the various investment categories such as property, equities and bonds it gives you a natural hedge against inflation based on fundamentals. For example, investors can move away from European government bonds and add corporate bonds with higher yields and emerging market bonds to their portfolio, which also gives some protection against inflation.
I think it is a mistake when everyone buys inflation-linked bonds purely for inflation protection purposes because, in an environment with sharply rising inflation and interest rates, you are exposed to the implied risk of rising real interest rates. We only have some minor exposure to inflation-linked bonds, as they are linked to the risk of higher real interest rates but they will give us a certain protection against rising inflation.
Austrian regulations do not refer specifically to inflation risk - it is entirely the pension funds’ duty to take care of that risk. In general, Austrian pension funds take a diversified portfolio asset allocation approach although, at the moment, we do see higher cash portions than in the past as a result of higher short-term interest rates and a very slow increase of other asset classes such as commodities, property and absolute return products.
Jari Eskelinen, head of fixed income and international equities at Finnish multi-employer pension fund Ilmarinen, which has AUM of around €25bn
Due to the flight to quality on the back of the credit crunch, the impact of rising inflation on our fixed income investments has been limited. But of course the returns of our fixed income portfolio have been affected, albeit so far to a minor extent because the five to 10-year rates have not been increasing with inflation.
High inflation has been one of the reasons we have not undertaken any major reallocation lately and not increased our current 37-38% allocation to fixed income.
But, although inflation has not affected our long-term strategic asset allocation, it has had some impact on our tactical asset allocation and what we do over the short-term. We believe that, to a certain extent, nominal yields will be increased by inflation and so we have been short on duration.
Inflation may make us consider tactical movements but it alone would not lead to structural changes to the portfolio. For this some other factors would need to be involved: for example, the risk premiums of different asset classes such as equities, real estate and alternatives.
Our allocation to equities is roughly at the same level as our fixed income exposure. We also have an exposure of more than 9% to real estate, which offers some inflation protection because the rental income is often linked to certain inflation indices. In addition, we invest in commodities due to their expected returns and decorrelation with other asset classes.
The real estate portfolio provides a reasonably good inflation hedge although we do not try to hedge inflation by using one single asset class against it. Due to the structure of the Finnish pension system, it would also be challenging to fully hedge our liabilities against inflation risk.
We have looked at the inflation swaps market but are not an active player there. In general, we follow the inflation swaps market but have made use of another type of over-the-counter (OTC) product that might increase in value with rising inflation.
But that is not a major part of our investments - it is driven more by portfolio managers’ interest in inflation scenarios.
Inflation-linked bonds form only a small part of our fixed income portfolio. We originally acquired them for diversification but they also offer some inflation protection. And if inflation expectations remain high in Europe we may increase that part of our portfolio.
Interviews conducted by Nina Röhrbein.