BT Pension Prepares For Inflation?
The UK’s biggest pension fund, the £39bn BT Pension Scheme, plans to increase its investments in inflation-proof assets by as much as £4bn over the next few years, paving the way for it to make more infrastructure investments.Earlier this year, up to 150,000 members of the BT pension scheme were asked if they would give up their guaranteed increases in annual pension payments in return for a rise in their initial income. The company has made a similar offer to other pensioners in the past and companies including ITV and Boots have done the same. But it's not clear whether this is a good deal for BT's members:
The pension fund, like many others in the UK, is exposed to inflation because it must pay out benefits in line with rising prices. This year, the scheme reviewed its investments in negotiation with BT, and has decided to double its target for these assets from 15% of its portfolio to 31%.
The scheme’s 2012 report and accounts, published last week, show that as of December 31 it had an inflation-linked portfolio worth £8.4bn. This is about 22% of its total assets, more than its previous target but well behind the revised one.
Of that figure, £6.7bn is held in “UK public sector” assets, likely UK index-linked government bonds, which are a good match for pension-scheme liabilities. The rest is invested in other countries’ bonds, inflation-linked corporate debt and infrastructure.
Last year, the scheme handed its in-house fund manager Hermes a new mandate to invest in mature infrastructure assets that generate inflation-sensitive income, including renewable energy. This portfolio, managed by Hermes’s GPE division, was worth £730m at year-end.
UK pension funds, especially larger ones, are increasingly keen on acquiring infrastructure assets outright.
Last week, a consortium consisting of the Universities Superannuation Scheme, the UK’s second-biggest fund; Borealis, which is the infrastructure-management arm of the Ontario Municipal Employees Retirement System; and the Kuwait Investment Office, announced an improved bid of £5.3bn for UK water company Severn Trent.
Ten UK schemes, including BT’s, have also agreed to put up £100m each for a new industry-wide Pensions Infrastructure Platform.
A spokeswoman for the BT scheme declined to comment.
Tom McPhail, a pensions expert at Hargreaves Lansdown, the financial adviser, said: "The BT scheme is looking for greater certainty by 'buying out' its unknown future inflation liability in exchange for a fixed price now. In the process it is shifting that uncertainty on to the member, who will then bear the brunt of any significant inflation in the future.It's worth noting UK pension schemes have been preparing for inflation for quite some time. The outlook for inflation was discussed at a conference held by the National Association of Pension Funds back in March 2011:
"If you are in poor health and therefore unlikely to benefit from long-term inflation proofing, this could represent a good deal."
The threat of high inflation concerns trustees of UK defined benefit pension funds for a cardinal reason. They are bound by law to increase pensions in payment, and deferred pensions, in line with inflation, although the liability is often capped. So, when inflation jumps, so do pension fund outgoings.The article above was written over two years ago and offers a good discussion on why UK pensions are worried about inflation and what options are available to hedge against rising inflation.
Such fears may prove unfounded in some cases though, advisers say. This is because if rising inflation exceeds the cap that limits the inflation-matching liability of many pension funds, it can help funds reduce their liabilities.
For example, if the inflation rate rose to 7 per cent bond yields would also be likely to rise. If the cap on a pension fund was set at 5 per cent, the current value of its liabilities would fall as they would be discounted at a higher rate.
“The worst thing that could happen to a pension fund is deflation. If inflation is a bit ahead of the consumer price index or the retail price index rate, then pension funds with a cap wouldn't have to increase their pension payments by more than that," says Jeremy Tigue, manager of the Foreign & Colonial Investment Trust.
Nick Sykes, partner with the pensions consultants Mercer, says the relationship between the rise in inflation and the size of liabilities is complicated as the methodology on inflation-capping varies so much from one pension scheme to the next.
Generous schemes are most at risk, meanwhile, as some still offer pensioners protection against the full brunt of inflation rises. The effects of inflation on pension funds’ assets also have to be assessed, Mr Sykes notes. The array of asset classes in which schemes invest has widened since inflation was last a threat in the UK during the early 1990s, but that may not necessarily help.
Commodities are generally viewed as providing inflation protection, for example, but Mr Sykes discourages pension funds from investing in the asset class. “Long term, we’re unconvinced commodities produce an attractive return. They don’t offer an income stream,” he says.
Real estate, however, remains attractive. “We quite like it. Its returns are strong and it offers some inflation protection,” says Colin Robertson, global head of asset allocation at Aon Hewitt, who is just as negative as Mr Sykes on commodities.
If inflation were to soar to stratospheric levels however, Mr Robertson argues that it would hit asset classes such as equities and be a “net negative” for pension funds. Funds with inflation-linked liabilities also face problems as they tend to underhedge exposure to inflation. Having said that, one must also consider the possibility that inflation may peter out.
Neil Williams, chief economist for Hermes, which looks after BT’s pension scheme, thinks that unless demand returns, the pick-up in UK inflation – which is being driven by rising oil and food prices – may fizzle out in a few months. “For past inflation to guarantee future inflation you need to have strength in the labour market,” he says. “The tension in North Africa and the Middle East and the disaster in Japan have added more threats to the outlook for economic growth.”
Regardless of the consequences, it stands to reason that the volatility whipping through markets in the wake of the situation in Japan and the political upheaval in North Africa, is only encouraging pension funds to rachet up their efforts to hedge portfolios against inflation risks. “There's been a surge in demand for inflation-linked bonds and this suggests to me that the world has in mind an inflationary future,” says Mr Williams of Hermes.
Mr Robertson of Aon Hewitt, and Mike Smedley, a partner in KPMG’s pension practice, agree. “A large number of clients are in the process of putting on de-risking strategies or taking out the inflation or duration risks arising from their liabilities,” says Mr Robertson.
Mr Smedley adds: “We’ve seen a steady growth in the number of clients who are interested in buying inflation protection. But a lot of clients don’t want to pay for it at current prices.”
Historically, index-linked gilts and swaps are the conventional ways to hedge against inflation. Of the two, swaps, a type of derivative by which a scheme pays a fixed rate (over the length of the swap) and receives the retail price index yield from the counterparty bank, remain more popular as they allow managers to deploy, say, just 20 per cent of their capital to gain 100 per cent protection on their portfolios.
However, Robert Gardner, founder of Redington, a UK pensions consultancy, says both investments are now a “quite expensive risk lever” for pension funds to pull.
Desperate times require creative measures. In the past year, Mr Gardner notes that more pension funds have begun to invest in municipal libraries or supermarkets with long-dated leases that are linked to either the retail price index or the consumer price index. “The point to note is that people are looking at property investments via a fixed income lens,” he says.
Mr Smedley says some clients have bought into RPI-linked bonds issued by National Rail. Yet he remains cautious on more unusual methods of inflation proofing. “Schemes out there are trying to do quirky things. But it can be hard to demonstrate that the quirky things are a good match to protect against inflation,” he says.
Direct infrastructure investments represent another way of hedging against inflation. These are long-dated assets -- much longer than real estate -- that provide strong, stable cash flows with built-in inflation hedges (although academics have challenged the widespread belief that infrastructure offers a good inflation hedge).
Earlier this week, I discussed the fallout of GPIF's new asset allocation and explained why it's critically important to get the inflation/ deflation debate right. Japan is trying to ignite inflation by lowering the yen to increase import prices, but if successful this policy will hit their bond and equity makets hard and export deflation to the rest of the world.
That's why many prominent economists still worry about a deflationary slump, like Japan. Deflationary fears are the main reason why commodities and commodity stocks have been hammered this past year. This is why it's hard to conclude the bond selloff is for real. Yields have risen because global growth is improving but absent real inflation pressures, there is no imminent threat to bonds (Read Bill Gross's latest, Wounded Heart).
All this to say that pensions can prepare for inflation but they also need to prepare for deflation and how it will hit their public and private assets. If a protracted deflationary slump occurs, all assets except bonds will get roiled. This will be disastrous for pension funds and the financial system, which is why central banks will fight deflation with everything they've got.
Below, author and well known bear,