Pensions Policy Institute – Industry view


Lauren Wilkinson is senior policy researcher at the Pensions Policy Institute


INFLATION CHALLENGE COULD PROMPT GREATER DIVERSIFICATION IN DC INVESTMENT


With price inflation reaching its highest level in 40 years and expected to rise fur- ther still, there are likely to be many impacts across the DC landscape. High levels of price inflation, especially over prolonged periods, have the potential to worsen retirement outcomes. For peo- ple in the pension saving phase, high inflation may reduce their ability to afford to contribute at an adequate rate, while pot values will be eroded if investment returns do not keep pace with inflation, depending on the types of assets in which they are invested. For people in retire- ment, the effects of inflation on retire- ment outcomes will be more immediate, especially for those drawing incomes from DC savings.


Although it is difficult to make predic- tions about the future trajectory of infla- tion, failure to account for inflation appropriately in DC investment strategies could cause pot values to be eroded and compromise the retirement outcomes of members. While pension scheme invest-


ment strategies already take account of the potential for inflation risk, they have not previously been tested by the high lev- els of inflation we are now seeing. As the DC market has grown rapidly in recent years, DC investment strategies have generally been constructed during and for disinflation environments, which may mean they are no longer as effective in a high-inflation environment. Any hasty changes made by DC schemes today in response to high levels of infla- tion could put member outcomes at risk if they are not appropriately considered. However,


if high levels of inflation are sustained, they may need to consider steps


that can be taken to introduce


greater inflation protection into their portfolios. This does not necessarily require them to make large scale shifts between asset classes within their strategy. Costs associated with changes to invest- ment strategy must also be considered. The cost of changing portfolio holdings can be considerable, given the, some- times significant, difference between buy- ing and selling prices, broker’s commis- sion and stamp duty on purchases. While current levels of inflation are higher than have been seen in the UK for many years, a number of asset classes with either implicit or explicit inflation protection have been developed and become more prevalent in the meantime. It is, therefore, worth exploring the fac- tors between and within asset classes that could present the opportunity to deliver value in a high-inflation environment. While pension scheme investment strate- gies will already include some level of inflation protection, the current situation


may necessitate consideration of whether there are practical ways of introducing greater or more effective inflation protec- tion into investment strategy, especially as there are now a greater range of accessi- ble alternative asset classes that could potentially offer natural, implicit or explicit inflation protection.


As in any economic climate, there are trade-offs associated with each asset class during times of high inflation, especially when coupled with uncertainty about future levels of growth. An overarching theme across the range of asset classes is that


investment decision makers will


need to be more educated about the finer details and characteristics of the specific assets in which they are invested. For long-term investors such as DC schemes, the appropriate response is unlikely to be one of large-scale divestment from any one asset class, but rather a more nuanced approach with a better understanding of the impact of inflation based on factors that can vary within an asset class. DC decision makers need to be prepared to adapt to a range of inflation and growth scenarios, as well as a range of other risks that must be taken into account, and this may mean broadening their investment horizons to consider a greater range of opportunities.


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ISSN: 2045-3833 Issue 118 | November 2022 | portfolio institutional | 11


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