13 Dec Pension Apprehension (Q2-22)

Inflation is hitting peaks across the globe not witnessed in decades. The reasons for this are now well publicized: governments ran enormous deficits during the pandemic and wrote cheques to individuals and companies, which in turn fueled demand for goods and services; the monetary base grew by the same amount in two years during the pandemic than it did over seven years after the Great Financial Crisis; the pandemic and then the war in Ukraine caused significant labour and supply disruptions. Whether inflation is temporary or a lasting problem will have major implications on financial markets and long term investment performance. As our investors know, we believe the inflation genie will be difficult to put back into the bottle, and that inflation is likely to form a new, higher base above central banks’ desired 2% level. Uncertainty around inflation expectations drives up risk aversion, which makes for a tough environment for financial assets, particularly given record valuations.

Some investors are more vulnerable to inflation than others, especially retirees. Retirement assets in Canada are largely held in defined benefit (DB) plans, which place the burden of higher costs generated by rising inflation on sponsors. These costs can become prohibitive for those DP plans that are auto-indexed to CPI; however, even plans without indexation, will be adversely impacted if they base member benefits on final average salary since rising inflation typically leads to larger future salary increases. Actuaries typically make assumptions about future inflation as a component of their actuarial discount rate and certain benefit calculations. For 2022, actual inflation assumptions for inflation are 2% but if realized inflation is higher, then the difference is an increase in an indexed DB plan’s liabilities.¹ This is a major reason why most private-sector DB plans have moved away from offering inflation protection.
Actuaries should increase their inflation assumptions to better protect against the eroding purchasing power of retirement benefit dollars; however, investment consultants would argue that revising only the inflation rate ignores the correlation that exists between inflation and interest rates and certain asset classes. If inflation remains high, interest rates would typically go up, as well as the return on equities over the long-term. DB plan sponsors would be consciously funding higher benefits with the expectation of receiving inflation generated investment returns. Unfortunately, chronically low interest rates enticed investors to chase risk and abolish fundamentals of valuation, causing a run up of prices that have front-loaded more than a decade of what would have been future returns. In a rising interest rate environment, the value of a DB plan’s liabilities may reduce, improving the financial position of the DB plan, but only if there’s no offsetting decline in the return expectations of the plan’s assets. Unfortunately, the outlook for pension fund returns is very low.²

In a lower expected return environment, selecting a portfolio to hit an overly aggressive return target can lead to adverse financial outcomes. Sponsors should be very cautious about simply taking on more investment risk to achieve a higher return. Over the next ten years, investing should focus on the pension plan maintaining solvency until a future environment offers more favorable investment expectations. Plan sponsors will need to lower their actuarial discount rates to reflect the direction of expected asset return projections. There is no asset allocation that can perfectly hedge against inflation risks but it is clear that some asset classes do perform better than others in inflationary environments. Not surprisingly, cash is usually the worst performer. Plan sponsors will have to look to alternatives that can protect the downside if risk markets correct and provide returns uncorrelated to other asset classes. Adding private debt, especially asset-based lending (ABL), makes a lot of sense for pension plan portfolios in the current environment. ABL provides good inflation-hedging potential because of floating interest rates, short durations, and the sources of protection and repayment (i.e., underlying asset collateral) increasing in value.

[1] FP Canada Standards Council, Projection Assumption Guidelines, effective April 30, 2022.
[2] The Pew Charitable Trusts, a non-partisan, global research and public policy firm, published a chartbook updating research on the performance of 73 of the largest U.S. state pension funds and forecasts typical pension fund portfolios to yield total returns of only 6%. May 2022.

Article excerpted from the Q2-22 investor letter