The prolonged and continuing slump that followed the financial crisis of 2008 has forced pension fund managers into a fundamental change in assumptions about the basic principles that should govern their investment decisions.
For pension funds that offer defined benefits tied to moves in consumer prices, one of the most important side effects of the prolonged downturn is the demolition of the idea that they no longer have to worry about high inflation.
By the early 2000s it seemed that in the rich world, inflation had finally been conquered. The European Central Bank and other monetary authorities were given the independence by politicians to keep it under control – sometimes aided by strict, well-defined targets. As a result, inflation became extremely low by the standards of the previous half-century. This seemed a rare case of an unalloyed triumph for economists. They had, as a profession, managed to solve a problem – high inflation – which had once seemed as certain as death and taxes. As a result, although pension funds still had to take account of inflation, allowing for it was a much easier job than it had been before.
But although central banks’ official inflation remits remain unaltered, the slump has destroyed their power to obey them. In the eurozone, for example, consumer price inflation has been above the European Central Bank’s upper limit of 2 percent throughout this year. In the UK, October figures show a rise in retail price inflation to a 20-year high of 5.6 percent. The global inflationary pressures which have brought this about – rapidly growing demand for commodities in the developing world – seem likely to persist for many years. But with economic growth so low – and likely to remain low in the developed world for the foreseeable future while fiscal tightening acts as a permanent brake – the ability of the European Central Bank and its counterparts to raise interest rates significantly to combat inflation looks limited.
If central banks cannot bring inflation down, pension funds must adopt investment strategies to deal with it.
Many investors regard investing in equities as a solution to inflation. But a close look at the inflation-ridden 1970s gives cause for pessimism. Research by Deutsche Bank shows companies’ profit and loss accounts showed healthy earnings growth. However, underlying free cash flows – a better guide to companies’ true performance, and, crucially, the pot of money from which dividends had to be paid – rose slower than inflation. As a result, investors were reluctant to trade stocks at high multiples to earnings. Forward p:e ratios fell accordingly – hitting share prices.
High inflation can boost companies’ cash flows with little difficulty if buoyant consumer markets allow companies to pass on their higher costs to customers. But the combination of high inflation and low economic growth – which marked much of the 1970s, and may be the leitmotif of the rich world for several years to come – is likely to limit cash flow increases. Low economic growth will eat into consumers’ real disposable income, by hitting employment, keeping wage growth low, and very possibly forcing governments to raise taxes to bolster receipts from their ailing economies. High inflation will hit consumers’ real income still further. In short, consumers will not be doing very much consuming – and that will hit corporate cash flows.
If investment in equities is not the solution to inflation, an alternative is to invest in commodities – the asset class which is causing the inflation in the first place. For many investors this works very well. But for pension funds, commodities present at least two problems.
Commodities are ill-suited to one of the big trends among pension funds – the move to liability-driven investment, based on securing regular and predictable income to meet regular and predictable liabilities. Unlike most other asset classes, commodities do not produce an income unless they are sold.
Commodities also fit awkwardly with the other major tendency among pension funds – their move towards “derisking”, which involves trying to reduce portfolio volatility. Commodity prices are highly uncertain, unlike death, taxes, pension fund liabilities – and, these days, high inflation.
