Pension schemes’ traditional asset allocations could lead to a significant fall in funding levels in a deflationary scenario while hyperinflation would dramatically improve their funding status, analysis by investment consultancy Redington, has shown. Further, the analysis provides evidence of how a more efficient portfolio could mitigate much of the deflationary risk.
Published today, the white paper assesses the impact of three extreme economic scenarios on a hypothetical pension scheme (Scheme XYZ), using two different asset allocations and hedging strategies:
• Stagflation: A dire scenario for Scheme XYZ as falling real yields drive up the value of liabilities while return-seeking assets underperform, reducing the funding ratio by a tenth. A more efficient asset allocation effectively neutralises this loss.
• Hyperinflation: Ironically, the most benign of the three scenarios for Scheme XYZ as higher nominal rates devalue liabilities and return-seeking assets perform strongly in nominal (though not real) terms, with the funding ratio more than doubling.
• Deflation: The worst scenario for Scheme XYZ as return-seeking assets plunge and the effect of falling inflation on liabilities is largely offset by falling nominal rates, taking the funding ratio down by 17%. With diversification into alternative assets, this blow is reduced to only 6%.
Mathias Rasmussen, Associate in Investment Consulting at Redington, said: “Our analysis shows the asymmetric risk faced by schemes in this uncertain economic climate. It is almost impossible to predict whether any of these scenarios will occur but it is possible to calculate their potential effect. The efficient portfolio shows how asset allocation can offer protection against a range of scenarios. ”
Alex Lindenberg, Associate in Investment Consulting at Redington, said: “Stress testing a scheme's assets and liabilities against extreme conditions allows decision-makers to understand and protect against the worst outcomes. It's a case of plan for the best but prepare for the worst. The analysis clearly shows deflation is the worst of these extreme scenarios for both schemes and their sponsors.”
The full publication can be downloaded free from Redington’s website:
Dire Straits: How Asset Allocation Affects Pension Scheme Vulnerability to Extreme Risks
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