There are systemic risks with defined benefit (DB) pension schemes’ inflation hedging, the Society of Pension Professionals (SPP) has warned in its latest research.

According to its Vision 2023 report, the inflation hedge of a DB scheme is imperfect because a Retail Prices Index (RPI) asset is used to hedge an inflation-linked liability, where the inflation linkage of the latter is limited by caps and floors.

“This means the amount of index-linked gilt exposure needed will change as inflation levels and inflation volatility change; but if pension schemes need to adjust their index-linked gilt allocations at the same time, this will cause problems in an asset with few other natural buyers,” the report explained.

The paper gave the example of when inflation expectations fall, pension schemes could be buyers of index-linked gilts as they expect the cap on DB pension payment increases to bite less, meaning liability valuations would again be more likely to change in line with inflation expectations.

“However, should UK inflation expectations fall significantly, and deflation become a possibility, the inflation sensitivity of Limited Price Indexation (LPI)-linked liabilities would decrease," it stated.

"With a zero floor to stop pension payments reducing in value in absolute terms, trustees would not want to hold too many index-linked gilts with coupons and capital redemption payments that would fall in a deflationary scenario.

“In these circumstances, pension schemes could become mass sellers of index-linked gilts, which would push implied inflation rates lower still – meaning there is the potential for another negative feedback loop akin to that caused by the mass selling to address the collateral squeeze in September 2022."

However, pension schemes rebalance their portfolios at different times, meaning this loop may be less dramatic than the gilt-selling spiral in September 2022, “but the impact could still be significant”, the paper added.

This risk could also be mitigated over time via the issuance of government bonds with an inflation floor at 0 per cent per annum, the SPP report suggested.

It stated: “This would remove the need for pension schemes to sell index-linked gilt holdings as inflation falls, given the inflation sensitivity of the assets would be more closely aligned with pension schemes’ liabilities.”

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