After being off of Canadians’ radar screens for years, the re-emergence of inflation in recent months is receiving significant attention for many, including pension plan professionals.
Some believe the inflationary increases will be transitory because recent price increases are primarily due to short-term disruptions in the Canadian economy caused by the emergence from restrictions due to the coronavirus pandemic. However, others are concerned that expansionary monetary policies employed by central banks to address the economic impacts of the pandemic and increases in government debt may lead to a persistent period of higher inflation.
If higher levels of inflation do, in fact, persist, there will be many implications for Canadian society, including for defined benefit pension plans.
Since the mid-1990s, the Bank of Canada has targeted an inflation rate of two per cent per year, within a range of one per cent to three per cent. The bank has been successful in keeping inflation within this desired range for much of the last 25 years.
Following a brief period of low inflation in 2020, the Canadian consumer price index has spiked in recent months and exceeded the Bank of Canada’s upper range of three per cent for the months of April through August 2021. This August, the reported consumer price index increase was 4.1 per cent, which is the highest reported monthly increase in more than 18 years.
While inflation has been relatively low for many years, a low inflation environment shouldn’t be taken for granted. For those old enough to remember, Canadian inflation exceeded five per cent for much of the 1970s and early 1980s and, in some years during that period, it exceeded 10 per cent.
A period of persistently higher inflation would have several implications for DB pension plans, including the following:
1. Plan funded positions
Historically, a correlation exists between inflation and interest rates. If long-term interest rates were to increase along with inflation, this would reduce pension plan liabilities in general.
For plans that provide automatic indexing to retirees, the decrease in liabilities due to interest rate increases will likely be offset by an assumption that larger indexing adjustments will be provided to retirees in the future. The amount of the offset will depend on each plan’s indexing formula (including any caps) and the extent to which the plan’s actuary assumes that inflation will increase in the future.
Also, for a plan with benefits based on plan members’ final average earnings, the decrease in liabilities will be partially offset by any increase in the assumed rate of future salary increases due to higher inflation expectations. Despite the above-mentioned potential offsets, higher long-term interest rates will still mean lower liabilities for most pension plans.
With respect to pension plan assets, if interest rates rise, the value of a plan’s fixed income investments such as bonds will decrease. This shouldn’t be a concern for plan sponsors as the primary reason for allocating a portion of a plan’s assets to fixed income investments is to create a better match with plan liabilities when interest rates change. It’s to be expected that, when interest rates increase, both the plan’s liabilities and fixed income investments will decrease in value.
The value of plan assets will also be affected by the performance of non-fixed income assets, such as equities, during a period of high inflation. If an inflationary environment is accompanied by high unemployment and a poor economy (i.e., stagflation), the investment returns on non-fixed income assets may also suffer, which could ultimately hurt the funded position of pension plans. In particularly extreme versions of this scenario, central banks may also suppress interest rates to stimulate the economy, making the situation worse for pension plans’ funded positions.
Despite several potential offsetting factors — and unless an investment strategy has been implemented that fully hedges the plan against interest rate risk — increases in long-term interest rates that may accompany higher inflation will likely result in an improvement in the funded position of many pension plans, at least in the short-term and assuming historic economic norms hold. Better funded pension plans will mean lower cash and accounting pension costs for plan sponsors.
2. The demand for pension benefit increases
Inflation erodes the purchasing power of a fixed pension and a relatively small increase in the rate of inflation for an extended period can have a material effect on a pension’s purchasing power. For example, an inflation rate of two per cent per year reduces the purchasing power of a fixed pension by 18 per cent over 10 years. By contrast, if the inflation rate is three per cent per year, the reduction in purchasing power over 10 years increases to 26 per cent. Therefore, a period of high inflation is bad news for a retiree on a fixed DB pension.
Prior to the period of very low interest rates experienced over the past 10 to 15 years, it was common practice for some pension plan sponsors to grant periodic cost-of-living increases to retiree pensions (for plans that didn’t provide automatic indexing). If we experience a period of high inflation during the next few years, plan sponsors can expect pressure from retirees to revive this practice. At the very least, one would expect increased demands from unions for pension cost-of-living increases for collectively bargained pension plans.
While the granting of cost-of-living increases may be more affordable if the funded positions of plans improve, there will be accounting and potentially funding implications associated with granting increases. Also, granting cost-of-living increases during a period of high inflation could create expectations that frequent increases will continue, even during periods of low inflation and low interest rates.
3. Risk management
When assessing pension risks and opportunities, plan sponsors should consider modelling various high inflation scenarios and examine how inflation interacts with various pension risks, such as longevity risk.
For example, if a plan sponsor’s objective is to reduce DB pension risk, a period of high inflation may provide de-risking opportunities if the funded position of its plan improves due to higher interest rates. Potential de-risking actions include moving to a low-risk investment strategy, purchasing a group annuity and winding up a plan. There are also risks associated with improved funded positions that sponsors should consider, such as trapped surplus.
While a high inflation environment is generally viewed as negative for the Canadian economy, the implications for DB pension plans are complex.
High inflation isn’t good news for a retiree on a fixed pension. For plan sponsors, if higher interest rates accompany higher inflation, their plans’ funded positions may improve. This would lower pension costs and may provide de-risking opportunities at an affordable price. However, plan sponsors may also face pressure to provide cost-of-living increases to retirees. Also, an extended period of stagflation may ultimately hurt the funded position of a pension plan.
This may be the time for pension plan sponsors to bring inflation back on their radar screens so they’re prepared for both the risks and opportunities that may emerge if the recent increases in inflation prove to be more than a short-term spike.