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Inflation’s big comeback: Should corporate pensions care?

It’s been a long time since anyone worried about inflation getting off the ground. That seems to be changing, and for corporate plans, we think the risk is greater for return-seeking portfolios than liability-hedging portfolios. But we also believe that falling inflation is more worrisome than rising inflation. In this paper, we consider the implications and the potential role of different return-seeking allocations in preparing for various inflation outcomes.

The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only. Please refer to the risk section in the PDF available below.

KEY POINTS

  • Funded-ratio outcomes are the priority for corporate DB plans. Consequently, inflation’s impact is primarily a concern for the performance of return-seeking portfolios relative to the unhedged portion of a plan’s liability. We think liability-hedging portfolios should remain focused on fulfilling their role of matching liability performance.
  • Falling inflation has posed a more significant risk to funded ratios than rising inflation, though inflationary outcomes have at times led to tail-risk declines in funded ratios.
  • Diversifying return-seeking allocations with return-seeking fixed income, real estate, and infrastructure may help reduce funded-ratio volatility and potentially provide downside mitigation versus equities in both inflationary and disinflationary regimes.
  • Traditional inflation-hedging assets (TIPS, gold, commodities, natural resource equities) can have shortcomings on a stand-alone basis in a funded-ratio framework.
  • Multi-asset inflation strategies may mitigate these risks and play a role in return-seeking allocations by potentially helping to hedge against an inflation-driven equity sell-off.

In our discussions with corporate defined benefit (DB) plan sponsors, inflation is a hot topic and understandably so. As my colleagues wrote in a recent paper, persistently higher fiscal spending coupled with the increasing willingness of central banks to tolerate — and even seek — higher inflation could bring an end to the disinflationary regime we’ve all grown accustomed to over the last several decades.

The question this leaves many asset owners asking is whether they should adjust their investment policy to account for inflation risk. In the case of corporate DB plans, we think this decision should be viewed through the specific lens of a plan’s funded ratio. As we explain in this paper, doing so reveals that inflation is a greater concern for a plan’s return-seeking portfolio than its liability-hedging portfolio. What’s more, we find in looking at different inflation regimes over time that falling inflation is typically a greater risk to funded ratios than rising inflation. With all of this in mind, we consider the potential role of different return-seeking allocations in preparing for various inflation outcomes and we offer thoughts on sizing these allocations and integrating them with a derisking glidepath.

Funded-ratio outcomes, not absolute returns, matter for DB plans

As a rule, a corporate DB plan’s focus is on improving its funded ratio, which proxies the ability of the plan to pay benefits as they come due. Rising inflation expectations may push up yields and pressure returns of long-duration liability-hedging assets, but rising yields also help reduce a plan’s liability and improve its funded ratio. We believe that plan sponsors, therefore, should not be concerned with inflation’s impact on the absolute returns of a liability-hedging portfolio, provided that portfolio is fulfilling its role and matching liability performance.

Instead, we think the greater concern when it comes to the funded ratio is the effect of inflation on the performance of a plan’s return-seeking portfolio relative to the unhedged portion of the liability. This is a result of the impact inflation (and deflation) can have on equities — the primary risk exposure in many plans’ return-seeking portfolios.

How equities have reacted to different inflation regimes

To illustrate, we looked at the performance of US equities during rising and falling/stable inflation regimes since 1965 (the start of the “Great Inflation” period) and compared it to the performance of…

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