How can pension plans position for potential deflationary or inflationary scenarios?

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Rising food and grocery store prices and cost of living concept. © Tero Vesalainen /123RF Stock PhotosWith so much uncertainty on the horizon, should pension plan sponsors be preparing to operate in a deflationary or inflationary environment?

In the short term, the economic environment will be deflationary, says Hugh O’Reilly, executive in residence at the Global Risk Institute, noting demand is down because people are staying home and not spending. “And we see this across the world. The lack of spending, the lack of demand, that creates deflation. And it creates downward pressure on prices.”

Deflation would mean a hit to pension liabilities on a solvency basis, says Daniella Vega, principal at Eckler Ltd. “On a solvency basis, if you were to enter a deflationary period where, for instance, interest rates had to be lowered or were low for a longer period of time to encourage spending, that increases your solvency liabilities.”

From a defined benefit plan sponsor perspective, a short burst of deflation could help mature indexed plans marginally because pension benefits wouldn’t be indexed and it would only result in a small impact on short-term returns, says Nathalie Proteau, associate partner and head of investment strategy for asset and risk management at Morneau Shepell Ltd. But if deflation persists, returns would likely fall, she adds, noting that, even if benefit indexation is floored at zero, pensions can’t be reduced beyond that, so the pension plan may lose more on assets than liabilities.

Proteau thinks an inflationary scenario is more likely than a deflationary scenario because of the level of government spending and low interest rates.

O’Reilly agrees that inflationary pressures could build over the longer term because of the amount of borrowing and spending that will be required. “Managing this as a long-term investor, I think, is going to take a lot of skill and a lot of talent and it’s going to be difficult.”

A high inflation environment could possibly boost DB plan funding because if benefits aren’t indexed, or indexation is capped, even with inflation, the impact on liabilities would be smaller than the impact on assets, notes Proteau. However, she adds, the situation would depend on a plan’s asset allocation.

James Davis, chief investment officer at the OPSEU Pension Trust, thinks the current environment is deflationary and that a continuation of low growth, low inflation and possibly deflation has already been priced into the bond markets and, to some extent, equity markets.

But the massive amount of fiscal stimulus, in addition to monetary stimulus, makes the current situation different than the past, he says. And he notes the unprecedented amount of stimulus could be inflationary. “I don’t mean just asset price inflation. I mean real inflation in the real economy because fiscal stimulus is putting money in the hands of consumers, whereas the monetary stimulus required the banking system as a transmission mechanism and that never occurred post global financial crisis.”

A deflationary environment with low interest rates pushes investors out along the risk spectrum. And, in this type of environment, the best asset to own historically is nominal bonds, Davis says. Investors can also own assets that are bond-like with stable cash flows that earn real rates of return that are higher than government bonds, like real estate and infrastructure.

On the other hand, nominal bonds won’t do well in an inflationary environment, he adds. “In fact, if . . . bond markets begin to sense that inflation may be something that policy-makers are not as concerned about, but might be right around the corner, then longer-term bond yields would start to move higher.”

Meanwhile, assets like infrastructure and real estate would still do well in an inflationary environment. For example, in infrastructure, certain assets have repricing mechanisms and in real estate, leases could be renegotiated and the replacement costs of the properties would rise as well.

In addition to deflation or inflation, Davis says a horrible situation would be a low-growth, high-inflation environment, since not many assets would do well in that scenario. “The best that you can do is take a longer-term view and try to be as balanced as you can and be aware of what the potential challenges can be and what tools you might have at your disposal to try to deal with them.”

Pension plan sponsors and asset managers need to do a lot of work plotting out various economic forces and trying to determine how these will affect their portfolios going forward, O’Reilly notes.

Vega also highlights the benefits of scenario modelling. “In an unpredictable environment, just having a thorough understanding of the what-ifs and scenario testing is a good tool because . . . you don’t really have a crystal ball. So I think you need to understand the impacts, or the ramifications, of different economic environments and look at your risk tolerance and your ability to withstand or plan for those types of situations.”

Diversification is key, Davis says. “You can’t put all of your eggs in one basket and say, ‘OK, well, I’m betting on deflation, so I’ll do a, b and c.’ You have to be thinking about, ‘Well, what if it turns out to be the other way around and it’s actually a stagflationary environment?’”

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