Local government pension payments will rise significantly next year based on the inflation rate this September. William Bourne discusses whether funds should be looking for some protection by turning to index-linked gilts.
Inflation in many countries is at levels last seen in the early 1980s, with the UK Consumer Prices Index (CPI) likely to reach double digits later this year. As LGPS pension payment increases are linked to CPI based on the September level, funds are bracing themselves for April 2023 when new rates kick in. This raises the question of what that might mean for contribution rates, which will change at the same time following the 2022 actuarial valuations.
Despite the headlines, most commentators think inflation is approaching its near-term peak. For example, the US Federal Reserve expects core inflation (i.e. without food and energy) to subside to 4.3% at the end of 2022 and 2.7% in 2023.
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Global recession
The UK bond markets’ break-even rate (i.e. the extra return investors require to take inflation risk) is 4% over both five and ten years. However, that is simply markets’ best expectation today, and the outcome will almost certainly be different. In the short term, food and energy prices will clearly remain high, and labour shortages are hiking costs there too. Against that, a global recession is looking increasingly likely, which ought to suppress demand.
The Fed raised interest rates by a surprising 75bps this month. It is increasingly clear that Fed chair Jay Powell sees a recession as necessary to control inflationary psychology. However, the US is not immune to demand pressures elsewhere in the world and there is no guarantee he will be able to achieve his objective. The Fed’s own end-2022 inflation forecast, including food and energy, is 5.2%, significantly higher than their core prediction.
In the longer term, some disinflationary trends have surely reversed: shorter supply lines are replacing globalisation; the supply of working-age people is starting to fall; and a more inflationary mindset is taking hold after a period of zero or negative price rises. There are also some emerging inflationary trends, such as the shift to renewable energy, where the need for new investment is imposing costs on consumers, and the impact of the war in Ukraine on food supplies.
On the flip side, technology will continue to disintermediate whole industries; and the bond market vigilantes are likely to stamp hard on countries who err egregiously.
Fed chair Jay Powell sees a recession as necessary to control inflationary psychology. However, the US is not immune to demand pressures elsewhere in the world and there is no guarantee he will be able to achieve his objective.
Supply-side inflation
I suggest the next rise in inflation is likely to be driven by the supply side, whether labour or key commodities (precious metals, energy, food). It may therefore fluctuate more than we are used to as commodity prices are affected by varying global demand and supply-side constrictions.
LGPS funds will be on the hook for near 10% rises in payments in 2023 unless the government steps in to cap them, as they have for student loans. It also seems inevitable that the assumptions in the 2022 valuations will incorporate a higher number for future inflation to reflect this unexpected near-term rise, regardless of the actuaries’ longer-term models. Strategic asset allocation discussions after the next valuation will be especially interesting.
The only asset class to provide complete protection against inflation is index-linked gilts (ILGs). Unlike the private sector, LGPS funds have tended to eschew them over the past few years. Today they yield around -1% i.e. investors are paying 1% a year for the benefit of receiving an inflation-linked income stream. There is a significant opportunity cost involved, especially for assets that do not mature for 40 or more years. However, ILG yields have risen to -1% having traded in the range of -2.5% to -3% in the preceding few years.
LGPS funds will be on the hook for near 10% rises in pension payments in 2023 unless the government steps in to cap them, as they have for student loans.
Investing in real assets
The more mature private sector pension fund industry with its greater emphasis on risk mitigation embraced ILGs 20 years ago. The LGPS, with a need to generate growth, has aimed to mitigate the inflation risk in other ways, such as investing in real assets which deliver inflation-correlated cashflow. Examples are real estate, equities and, more recently, infrastructure.
These only provide partial mitigation. Equity dividend streams should in aggregate grow slowly in real terms over the long term but over shorter periods may well show low or even negative correlations with inflation. Real assets depend on underlying contracts for their inflation protection attributes, but these often incorporate a cap to limit the annual increase. They will not provide protection if inflation is higher than the cap. And at times of stress, as we saw during Covid-19, real estate tenants may be unable to pay their contracted rents and companies may cut or pass dividends.
In the new and more unstable inflation regime we appear to be moving into, the value to pension funds of the inflation mitigation provided by ILGs must have risen, but at the same time the valuation the markets place on that attribute has fallen. It may be time to reincorporate them into inflation protection strategies.
Decisions will also have a direct impact on contribution levels. They have a legal duty to keep employer contributions affordable and stable, but it is not always possible to achieve both together. In the expected higher inflation environment, funds could tilt towards stability by raising contributions now and investing in sure-fire inflation hedges such as ILGs. They could even go further down the private sector route and use leverage to invest in them without compromising returns.
Alternatively, they could focus on affordability by keeping contributions lower while investing in assets such as infrastructure or real estate. In the latter case, if their investments turn out well, they will have succeeded in keeping contributions more affordable. But if they do not, they will have to raise contributions in the future and will have lowered contribution stability.
William Bourne is principal of Linchpin Advisory and has roles with five LGPS funds.
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