While no one can know for certain if inflation is coming bank, David Zanutto, senior investment consultant at Mercer, says that the risks of inflation moving higher have increased.
He points particularly to low levels of unemployment, which could translate to wage growth and higher inflation. Other factors that could lead to higher inflation include the impact of trade tariffs and the possibility that central banks might not be as aggressive in raising rates, he says.
But it’s all about timing.
The impact inflation has on pension portfolios will depend on how quickly it comes, Zanutto says.
But regardless of whether it moves fast or slowly, it is likely that interest rates will also rise, which would be negative for bond returns, in particular medium or longer-duration bonds, Zanutto says.
If inflation picks up modestly, other asset classes like equities would likely be okay, he says. But, if there’s a significant inflation surprise, he says even other asset classes like equities or real estate could suffer.
If inflation does come, how can plan sponsors prepare?
“In terms of the bond market, there’s going to be those investors–especially pension plan investors–that have a very strong risk-management focus, so they might well choose to retain their liability-matching fixed income investments even if they are of medium or long duration,” Zanutto says. He suggests that investors with less of a liability-matching focus should review their fixed income portfolios, potentially reduce the duration or look to floating-rate fixed income, like floating-rate notes or private debt.
Pension plans that have liabilities related to real yields should consider real return bonds at higher allocation, Zanutto says. “Real-return bonds have inflation links, but they tend to fluctuate a lot based on changes in real yields, which might not occur hand-in-hand with changes in inflation,” he says.
Zanutto also points to the potential benefits of absolute-return bond strategies, with lower duration exposure.
“In a rising interest rate environment, which we would expect to go hand-in-hand with a rising inflation environment, those strategies should hopefully still do better than plain vanilla strategies with quite a heavy exposure to duration.”
Moving beyond changes to bond strategy, Zanutto says that overall, plan sponsors could look for more exposure to assets like real estate and infrastructure, which would be dependable in multiple inflationary scenarios, especially given that a higher inflationary environment isn’t a certainty by any means.