UK defined benefit (DB) pension funds are likely to be exposed to losses worth £200bn because of their approach to securing inflation-linked returns on assets, recent PwC analysis has shown.

DB funds currently have £550bn invested in Gilts linked to the retail price index (RPI), making up the bulk of the whole index-linked Gilt market, the firm said.

It added that most pension scheme benefits are linked to inflation to some extent, “meaning there is a strong desire from pension fund trustees to cover that exposure, whether by directly investing in inflation-linked assets or other approaches” PwC stated.

But the firm claims the total UK DB pension asset base is £1.8trn, far outstripping available supply of index-linked Gilts. This is leading to prices being driven up by a supply and demand imbalance, it added.

Chris Venables, pensions partner at PwC, said: “The UK government could issue significantly more index-linked Gilts to address the supply and demand imbalance, so pension schemes can achieve a reasonable level of return.”

He said that currently new issues run at only about £25bn a year, but larger new issues “could exacerbate the distortions we are seeing”.

Investment in index-linked Gilts diverts money away from other income-generating assets which can generate positive real return, he explained.

Venables said that another option would be to make changes to pension regulations and policy to enable pension schemes to invest more freely in other income-generating assets.

“This would include ensuring the Pension Regulator’s new regime for funding pension schemes is not designed with reference to Gilt yields,” he said.

“If pension schemes continue to invest in negative real-yielding assets, then either there will be insufficient funds to pay all future pensioners, or their sponsoring employers will need to pay more money to subsidise the negative real returns. This could come at a cost of more than £200bn,” he added.

PwC analysis shows that for most of 2020, a pension scheme would have had to invest around £170 in a 20-year index-linked Gilt to receive just £100 on maturity in today’s terms. This would deliver a negative real return of -2.5% per year.

In November 2020, the UK government announced that the RPI would be reformed to follow the lower Consumer Prices Index (CPIH) measure from 2030.

The price of index-linked Gilts has not fallen to take account of reduced future maturity payments.

Unaware of lost value

Pension fund trustees, who are responsible for their overall asset strategy, may be unaware of the value they are losing, because information they receive is not typically presented in a way which highlights it, PwC stated.

The firm believes that investment return prospects are not often shown with reference to inflation, so “nothing may seem awry at first sight”. However, if the returns were shown allowing for inflation, and current asset prices were shown relative to historic levels, then what is happening and what the downside risks would become more obvious.

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