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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
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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.
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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
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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.
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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]
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