As implied future inflation goes below 2.5%, schemes’ liabilities tend to become less sensitive towards inflation, as pension decreases are often floored at 0%. At this point, schemes that hold index-linked gilts tend to become over-hedged on inflation.?
Schemes in this position will likely start selling their index-linked gilts to return their inflation hedging to the desired levels. As schemes begin to sell their index-linked gilts, there is downward pressure on the price of index-linked gilts, and implied inflation drops further, taking down the price of index-linked gilts with it. Once again, schemes become overhedged on inflation, and so begins the vicious cycle.
As pension schemes hold more than a third of gilts available in the market, the massive sell-off could have huge ripple effects through the market, mimicking the 2022 gilts crisis. LCP believes now is the right time to start thinking about deflation risk and making contingency plans.
Surendra Ravikumar, Analyst at LCP, commented: “Deflation is often the least thought about systemic risk, especially given that high inflation has been the issue of focus in recent times. As counter-intuitive as it might seem, pension schemes should be a lot more worried about the implied future inflation in the market rather than current inflation levels – if this implied inflation becomes negative, pension schemes could face the risk of a deflation spiral.
This is the right time for schemes to start thinking about the potential risk of deflation and to make contingency plans. Being prepared for different eventualities is a key lesson we all learned from the 2022 gilt crisis.”
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