UK – Pension funds in the UK could face a stagflation “predicament”, with schemes reliant on Gilt holdings to see positive returns, Redington has predicted.
In a brief paper on the impact of three economic scenarios – stagflation, hyperinflation and deflation – the consultancy outlined how a shift away from what it deemed a traditional asset allocation could be beneficial.
The hypothetical £800m (€927m) pension fund’s traditional allocation involved half of assets invested in the equity market, as well as an even split in the 35% fixed income portfolio between index-linked Gilts and corporate bonds.
The fund’s remaining assets were invested in alternatives, with a significant property allocation.
The consultancy said an alternative asset allocation – increasing the share of Gilts and credit to 40% overall and a further 10% in a portfolio of long-dated assets matching liabilities – would reduce the impact on the deficit from a 1-basis-point inflationary rise from by around £1bn to £300m.
Examining the origins of stagflation in the UK, it noted that the economy currently faced a “similar predicament” to that facing the country in the 1970s.
In its stagflation scenario, triggered by low growth prospects and the Bank of England repeatedly exceeding its inflation target, Redington said any equity holdings would underperform.
“Much will depend on the outlook for long-dated Gilt yields, the paper ‘Dire Straits: How Asset Allocation Affects Pension Scheme Vulnerability to Extreme Risks’,” it said.
It further noted that capital regulations currently in place could dampen any upward pressure on Gilt yields due to continued demand despite low real yields.
According to its estimates, the hedged nature of its proposed alternative asset allocation’s Gilt portfolio would be able to offset most of a £116m increase in liabilities, resulting in a £214m deficit and a funding ratio of 81% – compared with a 72% funding ratio on the traditional portfolio due to a more than £100m larger shortfall.
Mathias Rasmussen, associate in investment consulting at Redington, said the estimates clearly demonstrated the asymmetric risk facing UK schemes.
However, he added: “It is almost impossible to predict whether any of these scenarios will occur, but it is possible to calculate their potential effect.
“Stress-testing a scheme’s assets and liabilities against extreme conditions allows decision-makers to understand and protect against the worst outcomes. It’s a case of plan for the best but prepare for the worst.”
Exploring the possibility of hyperinflation, the consultancy said funds would likely see it as the most benign outcome despite its “severe” economic effects.
“This is primarily due to the structure of its liabilities,” it said. “In particular, the cap of 5% on inflation indexation means that, assuming no change in interest rates, the value of the liabilities will remain flat for any rise in inflation above that level.”
As a result, its predicted inflationary scenario saw the hypothetical fund report a significant surplus across both potential portfolios, and funding ratios of 189% to 193%.