Andrew Short explores the potential effects on pension schemes from the Bank of England's decision to embark on a second round of quantitative easing.
The Bank of England's Monetary Policy Committee voted on the 6 October to increase the size of the asset purchase programme by £75bn to £275bn, confirming the view that another round of quantitative easing is necessary to stimulate the ailing UK economy.
With inflation more than double the Bank of England’s 2% target at 4.5% – what does another dose of quantitative easing hold? Will it have any effects on pension schemes and should trustees be concerned if the Bank of England resumes its asset purchase programme?
To answer these questions is a tough call at the moment. As with all economics there is a certain amount of imagination involved and the solutions developed may not work so well in reality. There are complications and variables at every turn and this means it is difficult to call what will happen and when.
The initial bout of quantitative easing – in which the Bank of England purchased 200bn of assets from March 2009-January 2011 – did succeed in stimulating growth at a time when the UK economy needed it. The gross domestic product was boosted, as was inflation by around 0.75%-1.5%.
This is what the Bank of England is hoping will happen again should they restart quantitative easing. However, when the first tranche of quantitative easing took place it was at a time when the risk of deflation was high. Deflation was a threat because interest rates were cut to 0.5% and this did not have the desired effect of increasing lending. To remedy this, the Bank of England flooded the economy with extra liquidity to increase lending and stimulate the ailing economy.
However, today rather than worrying about the prospect of deflation we instead face the risk that inflation may soar to highs not seen for many years.
While market risk is a major worry for trustees up and down the country, inflation risk has also been steadily rising up the list. According to the Metlife 2011 UK Pension Behaviour Index inflation risk jumped up the importance rankings from the 14th most important risk in 2010 to fifth in 2011. The suggestion that the next round of quantitative easing is on the way may add to the fears that awe may see a high-inflation scenario.
High inflation hype
Inflation risk has typically been hard to quantify and, according to J.P. Morgan Asset Management European head of the Strategic Group Paul Sweeting, schemes must look at the split between current and deferred pensioners and look at the benefit structure to measure inflation risk effectively.
“It might be that you’re a pension scheme offering full indexation on all benefits regardless of legislation, in which case inflation risk is very serious. On the other hand you may only be offering what the legislation promises, so the risk is going to be lower,” adds Sweeting.
The large majority of pension schemes have caps on their index-linked liabilities. This means that once inflation hits this limit they no longer have to pay above this. There has also been significant movement by pension schemes into different inflation hedging instruments.
Barnett Waddingham partner Matt Tickle points out the best way of doing this is by using inflation-linked gilts and inflation swaps. However, schemes need to factor in the cost of this protection. He adds “schemes need to look around affordability as the first port of call.”
However PIMCO product manager Berdibek Ahmedov feels that the UK index-linked gilt market is very expensive because of the demand from the pension funds: “You have around £1.1trn of liabilities linked to some sort of inflation, where it is capped or floored or not, and you only have about £300bn of supply. There is a clear mismatch.”
P-Solve head of asset solutions Paul Kemmer also points out the problem with investing in gilts is that they only keep up with liabilities. “Pension schemes need to make more money than that,” says Kemmer “for most schemes, if you don’t outperform gilts you are not making up the ground you need to.”
According to Gatemore Capital Management managing partner Liad Meidar, there are other ways to capture the upside of inflation with commodities. “Historically, people think of index-linked instruments to fit their matching portfolio and that is appropriate,” says Meidar. “But we like to get some of our inflation protection from the growth portfolio and if inflation is moderate to high then commodities should perform well in this environment.”
