Are You Hedging Pension Inflation?

Since the Great Financial Crisis (GFC) many pension plans have shifted assets into either Treasury Inflation-Protected Securities (TIPS) or real assets (commodities) or both. The question that I’d ask is what are they trying to hedge? Is it asset inflation or pension inflation? If it is pension inflation then they are likely not hedging their exposures appropriately since pension inflation is very different from that of asset inflation.

Pension inflation is what a plan sponsor agrees to as a benefit increase as a cost of living adjustment (COLAs) for Retired Lives and a salary increase factor for Active Lives. Usually, these COLAs are based on the Consumer Price Index (CPI) with a floor and a cap or even a % of the CPI while salary increases tend to be quite static at a 3% annual increase. As a result, pension inflation tends to be less volatile than the CPI. The plan sponsor actuary includes pension inflation (COLAs and salary increases) in their projected benefit payment schedule for both retired and active lives. In sharp contrast, the CPI is a volatile measurement of consumer inflation.

In a quick screen of the Money Market Directory, it appears that roughly 730 DB plans have some exposure to real assets and another 120 use TIPS. I’m guessing that the plans are trying to hedge asset inflation, but that is purely a guess, fearing that the U.S. government’s multiple quantitative easing programs would create massive inflationary pressures. Well, that has obviously not happened. Inflation has been muted in the last decade with no calendar year since 2011 experiencing a CPI reading greater than 3%.

At Ryan ALM we are researching the subject of pension inflation versus asset inflation, and how that distinction impacts asset allocation. Please don’t hesitate to reach out to us if you’d like to get our thoughts.

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