UK inflation protection costs pushed up by DB demand

The demand for inflation protection from UK defined benefit pension funds is a key reason for higher than average market expectations for UK inflation, according to Legal & General Investment Management (LGIM).

LGIM head of multi-asset funds, John Roe, commented: “Unlike their US or Eurozone counterparts, UK pension funds will readily pay quite a premium for inflation protection. However, that premium is relatively unattractive for multi-asset investors, who we think can find better ways to manage UK and global inflation risks.”

Roe said that the UK is still the only place where the market-implied expectations for future inflation are above its central bank’s target. “We don’t believe this reflects a significant difference in the UK inflation outlook, but rather a market distortion caused by the unstoppable march of UK defined benefit pension schemes derisking and hedging their inflation-linked liabilities.”

Roe added that DB pensions de-risking is the main driver for market expectations that the Bank of England will overshoot its inflation target by 0.6-0.7% a year over 30 years, while the US and Europe will undershoot their targets by about 0.3-0.4%. “The main driver for these investors is to manage risk and, as such, they’re prepared to pay quite a premium to hedge their future inflation-linked pension liabilities.” He added that exposure to overseas currencies is a partial hedge to sustained UK inflation, as this would lead sterling to weaken. For global inflation, he said that inflation exposure in other regions, such as the US is more attractive.