Perspectives Deflation – the implications for pension schemes How likely is deflation? The Bank of England’s Monetary Policy Committee now thinks that there is a ‘roughly even’ chance of CPI deflation occurring in the first half of 2015 1, 2. The Centre for Economics and Business Research has predicted that the CPI will drop into negative territory in the year to March and the EY Item Club thinks inflation will fail to exceed the 1% mark until 2016. Whilst any period of deflation (falling prices) may be brief, the UK seems to be entering a period of low inflation in the short term. Consumer Price Index (CPI) inflation fell sharply towards the end of 2014, dropping from 1% in November 2014 to 0.3% in January 2015. This marked the lowest CPI figure on record (from 1989 to present, see Figure 01) and is estimated to be the lowest inflation rate for 50 years. Many commentators are suggesting CPI inflation could turn negative in the near future, as prices are pushed lower by the collapse in global commodity prices, by supermarket price wars and by weak or negative inflationary forces in the Eurozone economies. Percentage Figure 01. Annual inflation since 1950 30 “The Bank of England’s 25 Monetary Policy 20 Committee now thinks 15 that there is a ‘roughly even’ chance of CPI 10 deflation occurring in 5 the fi rst half of 2015.” 0 -5 50 19 55 19 60 19 65 19 70 19 75 19 80 19 85 19 90 19 95 19 00 20 05 20 10 20 15 20 Modelled CPI Estimated CPI Official CPI Source: ONS Economic Review, March 2015 2 Deflation and the implications for pension schemes towerswatson.com Whilst deflation was fairly common in the 19th century and in the first half of the 20th century, it is virtually unheard of in the UK in the post-war period (see the Bank of England’s ‘three centuries of data’). However, such low or negative levels of inflation are not unheard of internationally. Inflation in Japan fell below zero in 1999 and since that time has averaged -0.24% 3. Such prolonged bouts of very low or negative inflation are viewed by economists as damaging for the economy, being associated with low growth, high unemployment and financial stress. Good deflation and bad deflation Good deflation arises from favourable international shocks to prices, such as we are seeing currently with the fall in commodity prices. Falling prices (or even low inflation where wages are growing faster) increase the purchasing power of consumers, raising real incomes and acting as a boost to the economy. Falling energy costs are likely to help producers in other sectors. Such reductions in cost act to boost economic activity. By contrast, bad deflation arises from weak economic activity – where a lack of demand drives prices down across a broad range of goods and services. Deflation can become self-perpetuating; if consumers defer purchases in the expectation of prices falling in the future, companies may be forced to cut prices in an attempt to increase their sales, and reduce pay awards for workers. This increases the real value of debt, further reducing the spending power of firms and consumers. Can good deflation in the UK turn into bad deflation? Such a deflationary spiral may seem far-fetched for the UK, given the moderate levels of deflation expected and the relative good health of the UK economy currently. In isolation, the prospect of an extended period of deflation or low inflation would appear remote. Yet the economic forces driving inflation down are to a large extent external to the UK economy – a result of the dramatic fall in oil prices and the weakness in the global economy (with stronger economic growth in the UK, the pound has appreciated and the price for imported goods fallen). Where deflation or low inflation is a symptom of a wider malaise in the global economy, the increase in living standards it brings to the UK may then be temporary. Whilst it is clear the UK is currently facing ‘good’ deflation, the open question is whether a crash in the global economy could reduce confidence and lead to ‘bad’ deflation. “Where deflation or low inflation is a symptom of a wider malaise in the global economy, the increase in living standards it brings to the UK may then be temporary.” Japan’s experience shows that even moderate deflation or low inflation can persist for a long time, when combined with low growth, vanishing consumer confidence and monetary policy seemingly unable to kick start the economy. In Japan inflation has averaged only slightly below zero for the last 15 years but the economy has struggled to recover as wages have closely tracked movements in prices and consumers have been fearful about the future 4. 1 2 3 4 http://www.bankofengland.co.uk/publications/Pages/inflationreport/2015/feb.aspx The Retail Price Index (RPI) measure of inflation is expected to be around 1% higher than CPI over the long-term. So for RPI inflation to fall below zero would require the CPI to fall markedly below zero. The other route for RPI to fall below zero would be further reductions in interest rates. These are technically possible but currently viewed as less likely than a rate rise. Average between 1999 and 2013 (Source: International Monetary Fund, International Financial Statistics). Some commentators have argued that the adverse demographic situation associated with Japan’s ageing population has been a driving force in the country’s low growth experience. Even more controversial is whether more expansionary fiscal and monetary policy could have diverted Japan off this path. towerswatson.com Deflation – the implications for pension schemes 3 Implications for interest rates Low inflation is likely to mean a reduced likelihood that the Bank of England will raise base rates in 2015, with many forecasters suggesting 2016 is now a more likely date. In the unlikely event of sustained deflation, a rate rise could easily be deferred beyond 2016. Indeed, a number of central banks (the ECB, Switzerland, Sweden and Denmark) have introduced negative interest rates in response to fears of ‘bad deflation’. Whilst viewed as unlikely in the UK, the Bank has not ruled out such a tactic in the UK should the need occur. In February’s Inflation Report, the Bank suggested that it was viable for rates to fall below the current rate of 0.5% given greater financial stability in the UK’s banking sector: “The scope for prospective downward adjustments in Bank Rate reflects, in part, the fact that the United Kingdom’s banking sector is operating with substantially more capital now than it did in the immediate aftermath of the crisis. Reductions in Bank Rate are therefore less likely to have undesirable effects on the supply of credit to the UK economy than previously judged by the MPC 5 .” Such a cut in interest rates is particularly relevant to building societies, who are more dependent on depositors for funding and whose earnings are more exposed to movements in variable mortgage rates 6. 5 6 So what could deflation mean for pension schemes? For pension schemes, deflation could affect both cashflows and funding. The impact will depend on a number of factors, including the degree to which indexation and pension increases are linked to CPI (rather than RPI), the extent to which the scheme is hedged against inflation changes and the approach taken to setting the inflation assumption for funding purposes. “Where the inflation measure used to uplift pensions in payment is negative, many schemes will still not reduce pensions (and in some cases this may be explicitly written into scheme rules).” The timing of pension increases will also play a part; if inflation remains low or negative for most of the year, those schemes whose annual pension increase or indexation is based on September or December CPI or RPI will crystallise the lower figure in cashflows for the next year. Where the inflation measure used to uplift pensions in payment is negative, many schemes will still not reduce pensions (and in some cases this may be explicitly written into scheme rules). This means that cashflow will be higher than predicted by applying an inflationary (negative) increase. For many schemes the indexation measure used to uplift pensions prior to retirement will follow statute and will be subject to a cumulative cap over the period up to retirement; in this case a negative increase is more likely to be applied. See http://www.bankofengland.co.uk/publications/Documents/inflationreport/2015/feb.pdf. See http://www.economist.com/blogs/freeexchange/2015/02/british-monetary-policy?fsrc=scn/tw/te/bl/ed/wrongtarget 4 Deflation and the implications for pension schemes towerswatson.com Funding The funding implications will depend on the approach taken to setting the inflation assumption; this can be broken down into two broad types of approach: • Use of market-implied break even inflation, such as the Bank of England’s yield curves or the curve produced by Towers Watson. • Use of a long-term expectation, such as produced by an asset model or perhaps something even less market dependent, such as the Bank of England’s 2% CPI target. In the former case, changes in market expectations will automatically be picked up in the funding assumption. There will be an adverse short-term experience item to the extent that inflation-based pension increases are subject to a floor of 0%. In the latter case, there will also be a short-term experience item. In this case it will be by reference to the longer-term assumption made. To the extent that long-term expectations have not changed, there may be no need to re-calibrate the long-term assumption. It is possible then that even schemes that hold assets designed to match their liabilities will see a difference, since the floor of 0% applied to pension increases will generally not be mirrored by inflation-linked assets or derivatives. towerswatson.com In practice, though any differences are likely to be swamped by other effects: • Many schemes will have a broad inflation hedge rather than being precisely cashflow matched. • Whilst RPI remains positive, so will the indexation on RPI linked assets, meaning that they still exceed any CPI increases floored at 0%. The impact will depend on how the inflation protection has been designed. • Where schemes are under-hedged (that is they hold less by way of inflation hedging assets than implied by the liabilities), the unfavourable impact of the floor might well be offset by favourable experience of lower than anticipated inflation. What about the Pension Protection Fund (PPF) measure? Against the PPF measure, deflation will mean that there is less ‘drift’, since scheme increases for pre-1997 benefits will be brought into line with the zero increases provided by the PPF. For schemes that are hedged against scheme pension increases, the PPF funding level is likely to fall, as liabilities remain unchanged but asset values fall. “Even schemes that hold assets designed to match their liabilities will see a difference.” Deflation – the implications for pension schemes 5 Further information For further information, please contact your Towers Watson consultant, or Jonathan Gardner +44 1737 274097 [email protected] Martin Faulkner +44 121 644 7358 [email protected] 6 Deflation and the implications for pension schemes towerswatson.com About Towers Watson Towers Watson is a leading global professional services company that helps organisations improve performance through effective people, risk and financial management. With 15,000 associates around the world, we offer consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. Learn more at towerswatson.com Towers Watson 71 High Holborn London WC1V 6TP Towers Watson is represented in the UK by Towers Watson Limited. The information in this publication is of general interest and guidance. Action should not be taken on the basis of any article without seeking specific advice. To unsubscribe, email [email protected] with the publication name as the subject and include your name, title and company address. Copyright © 2015 Towers Watson. All rights reserved. TW-EU-2015-42717. May 2015. towerswatson.com /company/towerswatson@towerswatson /towerswatson
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