European Pensions Fret About Inflation Impact

(May 3, 2011) — European pension funds are buying inflation-protected instruments to guard their portfolios from increasing inflation, a Mercer survey shows.

The investment consultancy’s annual European Asset Allocation Survey of more than 1,000 European pension funds with assets of over $812 billion found that compared to last year, an overwhelming 80% of respondents are now more concerned about the threat of rising inflation.  

“Protection, through acquiring inflation hedging assets (such as inflation bonds and swaps), looks to be expensive and there is a risk that such investments provide ‘insurance’ for events that never actually happen,” Tom Geraghty, Mercer’s head of investment consulting for Europe, Middle East and Africa, comments in a statement. “Pension funds also need to understand the extent to which their liabilities are affected by higher inflation. In some cases, inflation caps may mean that higher inflation is less negative for pension schemes than might be expected,” he says, noting that it is imperative that schemes understand how their liabilities are impacted by various inflation scenarios.

Meanwhile, the study demonstrates that 18% of respondents are aiming to up their exposure to inflation-linked bonds, with 5% allocating to inflation-sensitive assets and 3% to inflation swaps.

“The last 12 months have been characterized by a general sense of unease and rapid swings from optimism to fear and back again,” Geraghty adds. “The use of loose monetary policies and quantitative easing has created the ideal environment for the re-emergence of inflation, which is a cause for worry for many pension funds.”

Schemes in both the UK and Ireland still have a bias in favor of equities, yet allocation to the asset class continues to decline year-on-year. In the UK, allocation to equity is currently at 47%, down from 50% in 2010 and 20 percentage points lower since the survey started in 2003.

According to the study, European funds are looking to increase their strategic allocation to non-traditional asset classes. On average, 22% of European funds intend to increase their allocation to emerging market debt (11% of UK funds). Over 6% of European funds plan to further diversify across debt markets through allocating more to distressed debt (7% of UK funds).

The departure from equities into government bonds, and the embrace of emerging markets is a familiar story among schemes. A March report by State Street Global Advisors’ (SSgA) shows that institutional investors should look toward smaller emerging markets to boost returns. “Investors, while maintaining a core exposure to BRIC countries, should not close their eyes to other growth areas in the emerging world,” Chris Laine, portfolio manager for active emerging market equities at SSgA, said in the report. “Many of the smaller emerging and frontier economies have quietly been making investor-friendly reforms and deserve the attention of international investors,” he said, referring to the smaller markets of Columbia, Turkey, Chile, the Czech Republic, Egypt, Hungary, Israel, Peru, Poland, Thailand and the Philippines.

A study this month by BNY Mellon Asset Servicing further revealed that UK pension funds have migrated into bonds from equities over the past decade. “In the UK and across the globe, pension demand for bonds will be rising over the next decade,” Guy LeBas, chief fixed-income strategist and economist at Janney Montgomery Scott LLC in Philadelphia, told aiCIO. “The financial crisis exacerbated this long-term rise to more conservative investments for protection,” he said.