DC schemes’ investment teams are increasingly having to factor in high inflation in their strategies and how it will, in turn, impact the relative value of currencies. Initially, this may seem at odds with the long time horizon of a DC scheme. While currencies can move sharply day-to-day, this has little relevance to a DC member whose retirement is decades in the future. It can be an issue, however, for those nearing retirement.
“Members are mostly exposed to currency fluctuations through their holdings in overseas equities, which are usually held during the accumulation/growth phase of lifestyle strategies,” explains Sonia Kataora, partner in the investment team at Barnett Waddingham.
“As a member approaches retirement, it is more important they experience fewer swings in the value of their savings to aid retirement planning, including fluctuations caused by currency movements. There is greater merit in currency hedging along the glidepath to retirement.”
Currency hedge
These currency fluctuations can have significant impacts on both a portfolio’s volatility and returns. Chris Inman, a partner at consultancy Aon, argues schemes should take currency exposure into considerations for members, and look at how these can influence both long- and medium-term decisions – but warns against the cost of this.
In particular, paying for currency hedging over the long-term could actually be counter-productive, he says:
“For DC schemes, the operational aspects require attention. Trustees should consider their specific circumstances and investment beliefs to ensure currency hedging yields a significant enough risk reduction benefit to overcome the added cost.” For this reason, Aon supports a “pragmatic” approach for DC schemes with exposure diversified across various currencies around the world.
Isio DC consultant James Hawkins similarly questions how much value currency hedging strategies ultimately deliver. “Over longer periods, currency fluctuations typically ‘wash out’ and all you’re left with is the additional cost,” says Hawkins. “However, in the run-up to retirement we believe there is a stronger case for currency hedging as the impact of volatility can often become crystallised at retirement with potential negative – or positive – implications.”
Steve Charlton, DC and solutions managing director, SEI says: “Interest rates and inflation metrics are useful indicators that can help develop robust currency assumptions that can be embedded in long term capital market methodologies to smooth returns and mitigate shocks. Emerging market currencies can prove less predictable and where there is evidence of a risk premia we will make adjustments to our models. While inflation has certainly been volatile of late, long-term inflation expectations tend to be more stable and we account for this in our long term investment ethos.”
Contending with high inflation
Inflation is a more persistent concern for DC schemes. Unlike daily currency fluctuations, high inflation represents a long-term challenge, with rates remaining stubbornly high around the world over the last year or more, despite the efforts of central banks.
This brings the issue right to the heart of DC strategy design. Steve Budge, a partner in consultancy LCP’s DC pension practice, says inflation can have a substantial impact on retirement savings and this has forced many schemes to review their investment strategies.
“Inflation is currently a very topical issue for DC scheme strategy design, given both the high levels seen in the UK and globally and how fast inflation expectations change,” says Budge. “This is requiring schemes to reconsider their strategy and potentially take a more active approach to managing duration risk.”
Investors’ expectation of an inflation-plus return has changed and this is feeding into scheme design and asset allocation choices. Head of DC strategy for EMEA at asset manager BlackRock, Dominic Byrne, is seeing a greater number of DC schemes consider private markets as a way of further diversifying portfolios and potentially providing some protection against inflation. He adds that asset classes that have historically provided protection against inflation – such as inflation-linked bonds, commodities, property and private equity – have become more attractive for schemes.
“In the portfolio construction process, the real [inflation-adjusted] expected return and the relative sensitivity to inflation across asset classes plays a role,” adds Byrne. “We prefer a whole portfolio approach as no asset or portfolio perfectly hedges inflation – returns will be linked to broad macro factors such as economic growth and interest rates.”
DC schemes would have to forfeit some returns to ensure they protect members from inflation. For instance, Legal & General Investment Management head of multi-asset funds John Roe points out index-linked bonds and commodities tend not to have very high expected long-term returns. This brings nuance to asset allocation decisions for members nearing retirement.
“We believe hedging inflation very closely would likely lead to an investment strategy with a lower expected return over the long term, with the median member worse off,” says Roe.
“Earlier on in DC members’ journeys, it’s probably better to make some allowance for inflation risk in the investment strategies, including investment in assets that might have some partial sensitivity to inflation. Even then, we would avoid too much reliance on that potential inflation sensitivity for any single asset class or region, [and instead] diversify where possible.”
James Monk, investment director for Workplace Investing at asset manager Fidelity International, questions the role of obvious choices such as inflation-linked gilts and the US equivalent TIPS. The higher duration and interest rate risks of these could become apparent to those nearing retirement, which highlights the need for forward planning.
“DC schemes should be considering the impact of varying inflationary scenarios on their members’ portfolios and finding ways to mitigate these risks, ensuring that the member outcome objectives of these schemes have been set with inflation incorporated into the design, so that all future modelling and design work considers and mitigates against this risk,” says Monk.
Charlton argues that a high-inflationary world raises the importance of active management. He says: “This is especially true during challenging macroeconomic environments, like those we are experiencing now. It is extremely difficult to achieve positive investment outcomes using purely passive management in an uncertain economy and our active approach has delivered real value for clients because our portfolio managers have been able to identify pockets of opportunity that have led to outperformance.”
Getting schemes ready
Inflation is not the dormant issue it once was. To combat it, a fast-moving interest rate environment could punish lethargy. DC schemes are becoming more active in their approach, regardless of the length of their members’ overall investment horizon.
“The impact of the recent spike in inflation has been the speed of the increase in interest rates, to rein in the market’s view of an increasingly high inflation outlook,” says LCP’s Budge. “A more active approach is needed when seeking returns from assets that have exposure to duration risk and, in particular, providing more timely management around short-term spikes in inflation, on the way up as well as when it starts to fall.”
Knowing how to respond when inflation starts to fall will be a challenge, as the data has so far wrong-footed markets and commentators alike. It is impossible to know how and when inflation will fall, making it difficult for DC schemes to prepare.
By their nature, DC schemes are slow to respond to changing market conditions. Barnett Waddingham’s Kataora advocates focusing on inflation-plus targets regardless of the outlook: “The aim is to achieve investment returns above inflation since this means members can retire with more money than they contributed to their pension after allowing for inflation. If inflation falls, then this may provide some respite for DC providers who have been battling high targets in recent years.”
High inflation has impacted many major economies around the world, creating cost-of-living crises and directly impacting consumer behaviour. This makes it a very hard-to-ignore economic issue, with an abundance of mainstream and political attention as a result.
Despite this, Isio’s Hawkins advocates for DC schemes’ investment teams to ignore the hype and maintain a long-term perspective, refraining from “knee-jerk” reactions.
“Strategies should be positioned to maximise growth in the accumulation phase and taking a long-term view on inflation expectations – this also extends to possible changes in other macro conditions,” says Hawkins.
Nevertheless, he argues DC schemes must also cater for members with shorter horizons: “When approaching retirement, minimising volatility and focusing on wealth preservation is more important. This is where we would expect strategies to be better protected against shorter-term rises, or falls, in inflation.”
