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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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