The 'Big Bang' theory of pensions
May 05, 2017
According to generally accepted wisdom, in the very early stages of the Big Bang, the Universe underwent a massive period of expansion called inflation, and the effects have been felt ever since. A different type of inflation has been continuing more or less since defined benefit pension schemes were created. And whilst the expansion of deficits in these pension schemes from falling bond yields has been well documented, the impact from the recent rises in long-term inflation expectations has come as a surprise.
PwC analysis, coming from our benchmarking analysis of the actual assumptions used by more than 100 companies at 31 December 2016 and stored on our Skyval Accounting and Consolidation system, shows that companies were, on average, assuming future RPI inflation of 3.3% a year for corporate reporting purposes at the end of 2016. This compares to 2.9% a year at the end of June 2016. It doesn't seem like much but, as ever with pension schemes, the effects are compounded. To illustrate: a 0.4% a year rise in long-term inflation expectations equates typically to a £20m increase in the IAS 19 accounting deficit of a £500m pension scheme - assuming no inflation protection has been taken out - so this is no small issue.
For some, the blame for this inflation is down to the decision to leave the EU, in particular falls in the value of sterling pushing up import prices. Many economists are not expecting this to reverse any time soon and, indeed, with interest rates being kept low to stimulate growth ahead of Brexit, it could get worse before it gets better. This has given companies and pension funds yet more reason to explore ways to reduce inflation risk through (1) entering into inflation swaps or buying inflation linked assets such as government gilts (2) offering pensioners higher fixed pensions in return for foregoing inflation-proofed promises and (3) transferring risk to insurance companies
There is one light at the end of the tunnel. The recently-published Green Paper on pensions suggests the possibility of all schemes being able to move from RPI to CPI for pension increases and revaluation in deferment. Many companies and trustees have already been exploring whether their scheme rules permit moving from RPI to CPI, if not automatically then through an allowable election made by the trustees. As these rules were often written more than 30 years before CPI had even been invented, it is not always easy to do. With CPI averaging 1% a year below RPI, the liabilities of a £500m scheme could easily reduce by £50m. Consequently, companies are putting in a lot of effort to make this happen.
The Green paper follows on from various other developments on UK inflation measures. For example, RPI inflation has been referred to in the past as "statistically flawed", as it can overstate true inflation due to how the formula works. There are those who view that as reason enough for schemes to move to another measure. RPIJ is an alternative but it is not widely used. Recent discussions have focused on whether CPI or CPIH should be the measure used in future. All this debate has been magnified by the Green paper and an ever-evolving legal landscape.
So whilst inflation is not expanding pension scheme liabilities as fast as it did the Universe, there are ways of mitigating the impact.