Cliff Taylor: Pension pots take a heavy hit as inflation upends markets

Have you checked your pension pot recently? Those relying on investments to fund their retirement income have taken a hit in recent months as bond markets have fallen sharply due to inflationary fears and many equity markets have also wobbled.

Inflation is turning the world of investment upside down and, added to fears of the impact of the war in Ukraine, has created a very challenging outlook for investors and fund managers,

1. Tough start to 2022

Pensions are a long-term investment. But it has been a tough start to the year for people in defined contribution schemes or with their own retirement funds.

Pension funds have had some strong years as equity and bond prices – their two main investments – have both risen.

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Bonds and equities traditionally move in opposite directions, but both gained in recent years, driven in part by the expansionary policies of the world’s major central banks over most of the last decade.

Now, however, the return of inflation has sent bond prices falling and the threat of higher interest rates – and the economic hit of the war – have unsettled equity markets.

Fund performance varies widely but many company or personal pension funds have lost 8 to 10 per cent in value in the early months of 2022. Many bond funds – which typically make up a significant part of a pension portfolio – are down by up to 15 per cent, while a lot of equity funds have also suffered.

Irish equity have had a poor run in 2022 – and are down more than 10 per cent on a year earlier, while major US markets have seen the post-lockdown gains wiped out and are roughly in line with a year ago.

In short, bar a few commodity funds, the funds that make up most pension pots are showing at best small gains and many are in the red for 2022.

After a strong run over many years, some kind of correction was probably inevitable at some point, according to Liam Ferguson, of financial brokers Ferguson & Associates.

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Most pension pots will still be well up over a longer time period – which is what is important for pensions – though the short-term outlook remains uncertain with interest rates rising and uncertainty in equity markets. And a lot of the gains made in more recent years have been sharply cut.

Big investment banks are now divided over the economic outlook, with some fearing that rapid interest rate rises by the US Federal Reserve Board could push the US into recession.

Deutsche Bank this week predicted a “deep recession” in the US, while other major players like UBS and Goldman Sachs see merely a growth slowdown.

A major Bank of Amercia survey of funds managers, meanwhile, showed a downbeat mood. The signs are of a tough time ahead for markets and thus for investors and funds, with big losses on bond markets in April adding to the problems heading into the second quarter.

2. The crux for investors

Investors have been pushed to take risk in recent years to get any kind of return on their cash. However low inflation meant the purchasing power of savings was maintained – unless you wanted to buy assets like houses which were rising in price.

For many investors and pension funds the circle was squared by sharp rises in equity and bond values, giving significant capital gains on their holdings.

Now those saving to fund their retirement face a conundrum, Ferguson says, with nervous bond and equity markets sending prices lower and the likelihood that capital gains will be harder won in future as central banks move to combat inflation.

In terms of an interest rate return, or yield, savings rates may now start to rise, along with the yield on bond investments, he said, though for now both remain well below inflation. But for now, protecting investments against inflation is very challenging and a continuation of the war and the associated uncertainty will leave markets unsettled.

For defined contribution pensions , funds have had a strong run for some years according to Munro O'Dwyer, partner at PwC and, with assets in some cases reaching very high valuations, investors may be giving back some gains which were never firmly based in the first place.

However “ future returns are likely to be hard won” as markets adjust to the new reality of inflation and face the continued uncertainties from the war in Ukraine.

Pensions are, by their nature, long-term investments, and Ferguson points out that those with a long way to go to retirement are generally best advised to ride out the ups and downs.

Those closer to retirement need to ensure their fund manager is de-risking their investment as they approach retirement, though as pension pots are generally rolled over now into retirement investment products – rather than used to purchase an annuity at a specific date – the risks of getting badly caught by a short-term market move are not so severe.

3. The defined benefit bonus

Most private sector employees are now in defined contribution pension schemes – where your pension depends on investment performance. But some older private sector schemes and many State companies still have defined benefit schemes, of which there are around 5,000 still in existence.

In these schemes retirement income is guaranteed as a percentage of salary, based on the number of years an employee has worked and contributed.

The rise in interest rates has provided a bonus to these funds, according to O’Dwyer of PwC. While asset value in these schemes has fallen – often by 8 to 10 per cent – the value of their liabilities has dropped even more, often by up to 15 per cent.

These is because the liabilities of these funds are priced off the cost of providing an income to retirees and thus falls as interest rates rise.

These will improve the position of many DB funds, pushing some into surplus and lessening the threat to companies holding these funds. This will start a debate, O’Dwyer says, over how this surplus is handled.

In some cases employers may seek to cut contributions, or employees could argue for enhanced benefits.The investment approach of these funds could also be tweaked as a more conservative stance could in future provide sufficient returns.

O’Dwyer says that the move to surplus could also make buy-outs – where a scheme’s accrued liabilities are moved to an insurer in return for a fee or premium – more feasible. This structure is normally used when a fund is being wound up.

Taking a longer-term view, the funding outlook for DB schemes would also be hit if we are entering into a period of slower equity market growth. How this will balance out with movements in liabilities is hard to predict, though for now this will improve with interest rate trends looking likely to be firmly upwards over the next few years.

4. Inflation changes a lot of things in the world of investment

A low inflation environment and massive monetary expansion by central banks has depressed yield from many assets classes, but led to significant capital gains.

Bonds and equities have thus moved in one direction. We may in time be returning to the kind of traditional pattern when investors are seeking to protect themselves against inflation, equity markets are tied more closely to economic growth and bond and equity investments move in the opposite direction. Time will tell.

In the meantime investors and pension fund managers face a difficult short-term outlook and a time of transition.