Soaring inflation will impact the Local Government Pension Scheme (LGPS) next year by significantly increasing pension payments and the demand for investment income.
According to the Office for National Statistics, the Consumer Prices Index (CPI) rose to 10.1% in the 12 months to July, which is up fro
m 9.4% in June and is the highest level since February 1982.
Iain Campbell, Hymans Robertson senior investment consultant, explained that LGPS pension payments are linked to September’s CPI, and, as a result, funds should expect payments to increase by at least 10% in April 2023.
He said: “From a cashflow perspective, this spike in inflation is pushing up cashflow payments by a rate not seen in decades, as benefits are linked to inflation.”
Investment income demand
George Graham, director of the South Yorkshire Pensions Authority, highlighted that once pension payments increase, they are not going to return to previous rates. Hence, many pension funds will need to find additional investment income.
“Once pensions have gone up by that 10 plus percent, they’re not coming down again, they’re just going to go up from that increased baseline, so our requirement for investment income will increase,” he said.
Graham suggested that finding the surplus investment income presents a challenge for the LGPS as pension funds belonging to the scheme are “more mature”, which means there are more members not contributing than active members contributing to the fund.
Once pensions have gone up by that 10 plus percent, they’re not coming down again, they’re just going to go up from that increased baseline, so our requirement for investment income will increase.
“So, the gap between the contributions we receive every month, and the amount we pay out in pensions every month, is getting bigger and bigger,“ he added.
However, given that funding levels are in general better than at any time since the 1990s, Graham said there is some capacity to absorb these pressures and harvest more investment income to plug this gap.
From a cashflow perspective, this spike in inflation is pushing up cashflow payments by a rate not seen in decades, as benefits are linked to inflation.
LGPS 2022 valuation
Campbell also pointed out that the LGPS’s 2022 valuation should not be significantly impacted by short-term inflation.
He continued: “Our valuation approach allows for shorter periods of large spikes in inflation within its stress testing, so we do not see this impacting any of the 2022 actuarial valuation results.
“The shorter-term impacts are different for different employers. Employers just a few years from cessation may see a notable impact on their valuation by this spike in inflation.”
Inflation mitigation
Both Graham and Campbell agreed that long-term inflation poses the biggest risk to the LGPS, and opportunities to mitigate its impact come from the funds’ investments.
Campbell explained that when it comes to long-term inflation “funds will want to invest in asset classes that generate returns with proven strong links to inflation over the long-term, such as equities, property and infrastructure”.
He advised that if funds wish to mitigate short-term inflation risks, they should look to invest in index-linked gilts, as returns are explicitly linked to inflation.
However, despite agreeing that index-linked gilts have traditionally provided inflation protection for pension funds, Graham said that “for quite a long time they have not necessarily represented a good value investment, despite the interest return being inflation linked”.
“One of the questions we will be asking is whether we would achieve better value by getting that protection somewhere else, even if it’s not precisely the protection you can get from index-linked gilts,” Graham continued.
Our valuation approach allows for shorter periods of large spikes in inflation within its stress testing, so we do not see this impacting any of the 2022 actuarial valuation results.
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