DB schemes need to pay more attention to inflation

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Volatile inflation rates mean schemes need to pay more attention to optimising their strategy for hedging against inflation according to new analysis from LCP, included in the consultant’s latest corporate report

Whilst for some schemes inflation hedging may be incomplete, leading to unexpected bills when inflation rises, LCP point out that schemes which have taken inflation risk seriously in the past could now find themselves over-hedged and could also look to make adjustments. 

In terms of schemes being under-hedged, new analysis from LCP shows that the impact of surging inflation has already added around £15 billion to the pension costs of UK DB schemes.  And a further £35 billion could be added to pension costs if the rise in inflation proves to be more than a temporary phenomenon.  

LCP highlights that even schemes which think of themselves as fully hedged could still be vulnerable to an upswing in inflation.  This is because it is common in DB schemes for this to mean hedging 100% of funded liabilities but not the deficit. This would mean that a scheme that is 85% funded and 100% hedged on assets could see their recovery plan contributions increase by around 20% or more if inflation rises by 1%. 

On the other hand, for schemes that were previously completely hedged against inflation, the inflation hedge ratio may have drifted upwards to 110-120% because of higher inflation and caps on inflation-linked pension increases. Schemes in this position should consider rebalancing their hedging approach and selling some inflation-linked assets. 

LCP are urging schemes to review their hedging strategy to avoid the risks of under or over hedging against inflation.  

‘Life through a lens’ also details the key issues that trustees and sponsors need to understand over the next few months as a result of the Pension Schemes Act and the new powers for the Pensions Regulator (TPR) that came into force in October this year: 

  • There are five steps that LCP recommends that company directors should take to avoid unwanted TPR scrutiny and manage reputational risk. These are:  
    • Company Board training on the new powers, 
    • reviewing corporate governance procedures around key business decisions,  
    •  considering how documentation and record keeping will work,  
    • reviewing any information sharing agreements with trustees and  
    • ensuring there are processes in place to meet regulatory reporting requirements. 
  • The new powers may provide trustees with greater leverage in M&A scenarios, and sponsors will have to show that they have worked through the impact of proposed transactions on the scheme. The details of the exact shape of these new requirements are currently being finalised.   
  • While the Regulator’s new funding code isn’t due to come into force until at least the end of 2022, when it does come into force it will likely mean trustees proposing higher deficits and shorter recovery plans for many schemes, regardless of whether they choose to be “Fast Track” or “Bespoke.” Sponsors currently engaged in valuations need to have an eye on their subsequent valuation which will be the first one under the new regime, noting there is still considerable uncertainty about exactly what the new regime will look like. 

The report highlights that while the amount of regulatory change in the pensions landscape can appear overwhelming, sponsors who keep a close eye on their scheme can seize opportunities that might otherwise be missed. This includes:  

  • Use of ‘contingent assets’ can help avoid locking up money unnecessarily in the pension scheme and can also help reduce levies paid by the Pension Protection Fund. 
  • Market movements can make ‘buying out’ your pension liabilities once and for all a more viable option, provided that you are ready to seize the chance; 
  • There are fears that the ban on contingent charging is pushing up adviser fees and may put people off seeking advice.  This makes it even more important for sponsors and trustees to consider offering IFA support to their members. 

Phil Cuddeford, lead author of the report and Partner at LCP, commented: “The resurgence of inflation could lead to big bills for many companies, especially where their pension scheme had not taken steps to protect against rising inflation. Even if you think you have the right protections in place things can change quickly in either direction – up or down.  Reviewing hedging strategies is a must, and this could also free up risk budgets to invest in more return seeking assets such as equities, private credit and property.” 

Gordon Watchorn, Head of Corporate Consulting at LCP, added: “TPR’s new powers from the Pension Schemes Act means that companies will increasingly have to make decisions through a pensions lens. However, some of the changes present excellent opportunities for scheme sponsors to set their schemes on a sustainable footing.   

“Understanding what to do in practice about the new regulator powers, reviewing the long-term pension strategy, and proactively addressing the scheme investment strategy are three key steps that every scheme should be taking.” 

Life through a lens

Life through a lens

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