UK inflation rate increase is bad news for pensions

The increase in CPI inflation for May was expected, and currently stands at 2.6 per cent [in July].

As well as the obvious reduction in disposable income, the increase will also have major implications on UK defined benefit pension schemes.

When valuing defined benefit pension scheme liabilities, one of the things taken into account is the investment markets' long-term view of inflation.

Pensions generally increase each year in line with inflation and an increase in inflation means that a higher value is placed on defined benefit liabilities.

This, compounded with low interest rates, means that the deficits of UK defined benefit pension schemes are expected to get even bigger than they are at the moment.

There are a couple of ways to try and protect a defined benefit scheme from inflation increases, including introducing a liability driven investment mandate.

The long-term consequence of this could be that employers have to pay more into their schemes or, as we’re seeing happen more frequently, many may no longer feel that they can continue to support the schemes and will close them to further benefits and offer an inferior defined contribution arrangement in its place.  

There are a couple of ways to try and protect a defined benefit scheme from inflation increases, including introducing a liability driven investment (LDI) mandate which will enable pension schemes to use inflation swaps so they pay a fixed rate of inflation and receive whatever inflation turns out to be.

Alternatively, the defined benefit scheme can invest in assets where the capital value and income are linked to inflation, known as 'real assets'. Examples include index-linked bonds and infrastructure.

However, the main drawback with these assets is the accuracy of the inflation hedge.

An LDI strategy, on the contrary, will closely match pension liabilities and can also be put in place quickly and at relatively low cost.

Stuart Price, is a partner and actuary at Quantum Advisory