Gilts deflation worry for pension schemes

Pension schemes holding index-linked gilts as a match for pensions in payment need to be aware that the investment return on the gilts will reduce as a result of deflation, says actuarial firm First Actuarial.

Both the coupon – the six-monthly interest payment – and the redemption proceeds on index-linked gilts are defined at the outset and change in line with the retail price index (RPI). When inflation is negative, as it currently is, it results in both the coupon and redemption proceeds falling.

Whilst deflation may be an immediate issue for pension schemes, the longer term position should not be forgotten, says Alan Smith, director, First Actuarial.

Smith says: “Many schemes hold index-linked gilts as a match for pensions in payment. However, an issue arises when inflation is negative because pensions in payment cannot be reduced but proceeds from index-linked gilts will reduce. The market’s expectation is that inflation will start rising again and increase to over 4 per cent in nine or ten years’ time. If this is borne out in practice then the cap on pension increases may limit the overall rate of pension increases to below the RPI.

“This is most likely to occur where the cap on inflation is set at 2.5 per cent or 3 per cent per annum. This limit on future increases may be of some relief to employers with schemes where negative inflation cannot be passed on to members.”