Inflation's impact on pension plans: navigating the storm

Over the past three years, we've found ourselves sailing through turbulent waters of remarkably high inflation. This surge in inflation can be attributed to a multitude of factors – the unprecedented government support during the pandemic, the relentless expansion of government deficits, supply chain disruptions due to geopolitical issues, the accelerating shift towards renewable energy as part of the green transition, and the retirement of the Boomer generation.

Since the middle of 2020, we saw prices rise from a modest one percent to slightly over nine percent by the middle of 2022. In response, both the Federal Reserve and the Bank of Canada have undertaken an assertive tightening cycle, increasing interest rates from a meager 0.25 percent to five percent. As of July 2023, inflation has gradually subsided, and wage pressures have eased, with the inflation rate resting at a little over three percent. Unemployment figures also shifted from 3.4 percent to 3.8 percent in the US and from five percent to 5.5 percent in Canada.

Naturally, every asset manager is grappling with a critical question: Is this inflationary surge structural or transitory? On the one hand, substantial indicators are suggesting that inflationary pressures will persist over the next few business cycles. Factors like structural deficits, deglobalization, and a shrinking labour force paint a picture of enduring inflation. On the other hand, we've witnessed an aggressive tightening cycle and the potential for increased productivity through technological advances like generative AI, which could counteract inflation by boosting productivity. Regardless of the outcome, it's imperative, both as a beneficiary and a pension manager, to understand the effects of inflation on pension plans.

There are two types of pension plans: defined contribution (DC) and defined benefit (DB) pension plans. Under DC, the beneficiary takes the risk of a shortfall, while under DB, the sponsor takes the risk of a shortfall.

Effects of inflation on DB plans

In theory, the rapid surge in long-term interest rates, coupled with increasing inflation, should shrink pension plan liabilities due to a higher discount rate applied to these liabilities. However, this reduction in liabilities will be counterbalanced by the forecasted duration of inflation under the indexing method or the projected wage increases under the final average of earnings method used to calculate pension payouts.

On the asset side, the rapid rise in interest rates has affected fixed income portfolios, especially those highly exposed to long-duration bonds. If these assets were used to match liabilities, the sell-off should not be an issue. However, if the asset manager was overexposed, this could be problematic over the long term if inflation persists and rates stay high. For non-fixed income assets, performance depends on the manager's exposure. Over the past year, long-duration equities were flat to down from their 2022 peak. However, value stocks, especially those in the energy space, have performed significantly better. Therefore, if the manager rotated into sectors that benefited the most under an inflationary environment, the asset side of the balance sheet may have performed well. Additionally, if the manager held alternative assets, especially residential, industrial, and storage real estate, returns may have been even better.

In the short term, the plan's status hinges on the asset mix and the offsetting effects on the liability side. Generally, well-funded plans will incur lower cash and accounting pension costs for the sponsor.

However, looking ahead over the long term, persistent inflation could spell trouble for pensioners on a fixed income with plans lacking automatic indexing. Small differentials in inflation can lead to substantial losses in purchasing power since losses compound. For instance, a two percent inflation rate over a decade result in a 22 percent loss of purchasing power, while three percent inflation over the same period leads to a 34 percent loss. If inflation lingers, retirees may pressure pension plans for cost-of-living adjustments or retroactive payout increases to match inflation, jeopardizing the plan's funding status and increasing pension costs for sponsors.

Effects on DC plans

In DC plans, the beneficiary bears the risk of a shortfall. Therefore, beneficiaries must select managers with experience in managing assets during inflationary periods. These managers should offer more complex strategies than simple 60/40 or glide path strategies, as plain vanilla bonds, a significant component of these strategies, tend to underperform during inflationary periods.

Which asset classes shine during inflationary periods?

In periods of high inflation and high growth, the top-performing assets typically include:

• Commodities: Commodities tend to be in high demand during periods of high economic growth coupled with high inflation. Furthermore, specific to this cycle, the world has underinvested in commodities for at least the past 10 years, creating shortages in metals and energy. A significant CAPEX cycle would be needed to bring the market into balance.
• Real Estate: Real Estate tends to be a good hedge in inflationary periods since rents reset at higher rates. As a rule of thumb, real estate assets with short leases and high demand tend to perform best. For example, short-term rentals and storage units perform better than commercial leases due to their shorter lease terms.
• In periods of high inflation and low growth (stagflation), historically, the best-performing assets are:
• Inflation-Protected Bonds (TIPs): These government-issued bonds carry no default risk and are highly sought after in low-growth periods with increased default risks. Additionally, coupon payments adjust to reflect the higher principal amount, indexed to inflation, safeguarding investors against inflation.
• Gold: This asset class excels in high-inflation, low-growth periods, serving as a safe haven asset. Gold performs best when nominal yields dip below the inflation rate, a scenario often seen in stagflation, as central banks are cautious about raising rates significantly due to fears of pushing the economy from low growth into recession.

Looking Ahead

In the short term, the inflationary pressures witnessed over the past few years may have improved the funding status of defined benefit pension plans. However, over the long term, if inflationary pressures persist, sponsoring entities may face demands for cost-of-living adjustments from beneficiaries/retirees, potentially undermining the plan's funding position.

For DC plans, beneficiaries must seek experienced managers with flexible mandates that incorporate alternative strategies to hedge against inflation. During inflationary periods, simple strategies like 60/40 portfolios or glide path strategies prove inadequate.

As of today, the certainty of this inflationary period being transitory or structural remains elusive. As mentioned earlier, compelling arguments exist for both scenarios. Ultimately, only time will unveil the truth. Nonetheless, pension managers must comprehend potential risks and prepare for a scenario in which inflation and rates remain elevated for an extended period.

Joseph Pochodyniak is a senior portfolio manager at MacNicol & Associates focused on Real Estate, Private Equity, Hedge Funds and alternative asset class strategies. He is a CFA Charter holder since 2005 and obtained his Derivatives Market Specialist and FCSI designations from the Canadian Securities Institute in 2006.