Price risk protection
This month’s Off The Record survey focused on inflation. The vast majority of respondents (66%) believed that low inflation of less than 3% was likely in the next 12-18 months. A Dutch fund commented: “Currently, [we] do not see inflationary pressures to justify high inflation expectations. Furthermore, the European Central Bank’s monetary policy will be tilted to be more restrictive if and when an inflationary environment is anticipated.” A Danish fund added: “Economies are recovering slowly and at present only working at 70-75% of total production capacity”.
Some 17% of respondents felt that inflation would be higher than 3% in the medium term, but it would be under control. Just 5% believed that inflation would be higher than 5% in the medium term. “Government action through quantitative easing (QE) will result in inflation. Inflation [is] attractive to governments as it removes/reduces the debt”, said a UK fund.
Another UK fund stated: “Local recessionary pressures are likely to be offset by economic growth in BRIC and other emerging markets, which will cause commodity and import price inflation.”
Just one respondent thought deflation was likely, while 10% felt it was not possible to be sure what scenario was probable over the next 12-18 months.
Some 78% of respondents said that their pension fund’s board or investment committee had discussed the issue of inflation in 2010. There were various outcomes to these discussions, with one UK fund, among others, “considering interest and inflation swaps for 2011”.
Inflation linked bonds were considered the asset class best suited to provide pension funds with inflation protection by 68.5% of respondents. A Dutch fund commented: “With inflation linked bonds you are able to protect yourself against inflation volatility”, while a UK fund added: “Inflation linked bonds should produce nominal return to maturity, plus CPI/RPI protection.”
Inflation swaps or swaptions were the next most popular asset (chosen by 46.5% of respondents), closely followed by real estate (44%) and equities (39%). “Equities should produce real investment returns over the long term, [and] real estate should produce returns between those of equities and inflation linked bonds, both of which should provide inflation protection”, said a UK fund.
Some 24.5% of respondents thought infrastructure would provide funds with inflation protection, 17% commodities and just 7.5% forestry.
More than 97% of respondents had seen their pension fund make a dedicated allocation to equities. This was followed by 75.5% with an allocation to real estate, 57% to inflation linked bonds, 43.5% to commodities, 18% to infrastructure, 15.5% to inflation swaps or swaptions, and 3.5% to forestry.
The average fund allocation overall to inflation linked assets, excluding equities, was 14%. A quarter of respondents had a 0% allocation, while a Portuguese fund had the highest allocation, at 90%.
Just 15% of respondents stated their fund currently used inflation swaps or swaptions to protect against a rise in the real value of liabilities. However, of the 85% who did not currently use swaps or swaptions, almost half (45%) said they would consider using them in the future.