PTL Blog

UK Deflation: Bonanza for Members?

Posted by Colin Richardson on Jan 20, 2015, 2:47:00 PM

Following the headline "UK inflation falls to 0.5%" all forms of media are full of economists speculating on whether the UK may enter a prolonged period of deflation and, if so, what the impact may be.

Very few comment on the likely impact on pensions...

Mathematically

The impact compounds. Not much impact with a small shallow deflation, but dramatic impacts for a prolonged deflation "spiral" or (to quote the apocalyptical jargon) if the UK gets sucked into a "Euro deflationary vortex."

5 years at 2% lower inflation than otherwise gives over a 10 per cent impact. 10 years at 3% gives a 34% impact.

deflated_balloon_-_cropped

Defined Benefit (DB)

There may be less future DB membership these days (in the private sector, anyway) but there remains a large body of deferred and pensioner members.

The impact of deflation would be positive for DB members and costly for DB employers. Deflation or indeed prolonged very low inflation leads to lower pension amounts in monetary terms but higher amounts and value in real terms. Non-increasing pensions increase compared to their value expected under higher inflation. Increase limits are less likely to apply. Negative inflation increases all pensions in real terms unless, exceptionally, a negative increase is applied.

This would be bad news for employers because the real cost of funding the pensions increase. The extent, however, depends on whether the reduced inflation or deflation has a knock on impact on investment markets and, in particular, long term UK Government bond yields. For most pension investment it is the "real yield" which matters. If lower inflation leads over time to lower bond yields, then the bonds held already increase in monetary value. The impact varies from scheme to scheme depending on the mix of pension benefits and the mix of investments held. Generalisation is too simplistic: suffice to say real costs increase under a deflationary scenario with a varying impact.

Employers may be getting a multiple whammy here. They may have lost some market pricing power for their goods and services and also may find an increased real wage bill even with no wage increases being granted. Employers with corporate debts also find these increasing in real terms. In addition, deferred members still in employment may find real wage increases without receiving a monetary increase as well as a rise in their pension benefit real values.

Of course, with much DB being in the public sector the tax payer is the one losing out.

Defined Contribution (DC)

The impact here is if anything, more complex. For anyone still buying an annuity (if anyone) the real cost of a pension with inflationary increases in payment should not, in theory, move in real terms over the long term, again depending on UK Government bond yield movements. The cost of a non-increasing annuity rises in real terms because the expected reduction over time of the real value pension income becomes lower (or nil if we never have future inflation). In the deflationary vortex the pension increases significantly in real terms. The real winners would be those who already have purchased non-increasing annuities which may or may not be appreciated amidst all the press comment on having missed out on the post April 2015 flexibilities.

For individuals not yet retired there is a pre retirement and post retirement mix of impacts. The post retirement impact should largely be as above for annuitants whether taking flexible income drawdown or purchasing an annuity. The method of receiving pension is in the end just a method and the deflationary impact on the money is the same. Assuming all else being equal there is a greater incentive to take more cash sooner than would otherwise be the case (if you think about the maths, although it depends on how it is invested). It is an incentive at the margin unless, of course, we enter the vortex beloved of commentators.

However there are other impacts (DC). No change to monetary contributions results directly but real terms future wages and contributions would be higher in real terms as wages would have increased in real terms. Beneficial to employees but costly for employers.

Investment performance pre retirement would be impacted, depending on the investment mix. In theory, bonds should mirror the inflation change to some extent and it is growth assets where the larger impact may be. Not so good for most equities one imagines given the difficulties deflation may cause most companies. Of course a nil movement in share price would equate to a real increase but the likelihood would be of a lowering share prices, and property prices and most growth asset prices.

In context, all individuals and employers have other non-pension impacts. Some of these are speculative and poorly analysed by commentators. The simplified statement from many about low interest rates hitting savers is misplaced in any event and becomes inverted with deflation because existing savings increase in real terms value and prolonged deflation makes a nil rate of interest a real return. Vice-versa for those with debts. The cash-flow impact on debt depends on the mix of fixed and floating rate interest. All assets held by all people are impacted in varying ways. This is before we consider the general economy, and the strain on government finances from many avenues, not least debt dynamics, to use the official lexicon. It could be argued that these wider problems outweigh the narrower pension scheme value increases for members, but I'll leave you to consider your view.

So, we can see within pensions some general impacts of positive real value for pension members and higher pension costs for employers (in real terms) resulting from prolonged deflation, but it is complex and there are multiple knock-on and wider impacts. Of course, deflation has many economic impact issues far wider than pensions for the economists to debate.

For trustees and investment managers making investment strategy calls, and design decisions on DC default funds, it is not clear how these risks should feature or be dealt with. After all, whether prolonged deflation may occur is speculative to say the least and we haven't seen it for nearly 100 years! Mind you, we haven't seen the developed world struggling with so much indebtedness ever before.

Where there is agreement amongst most is that significant deflation is best avoided and any pensions gains may be outweighed by other impacts.

 

Topics: Defined Contribution, Pensions, Defined Benefit

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