Just as signs of a recovery are emerging, some institutional investors globally are now guarding investment portfolios from the potential risks of both deflation and inflation.
Among those grasping this nettle are: Abu Dhabi Investment Authority, one of the world's oldest and largest sovereign wealth fund with assets estimated to be at least $300 billion; the 400 billion Danish kroner ($75 billion) ATP pension fund; and Rio Tinto PLC's pension funds, which have about $10 billion in assets worldwide.
The world economy is expected to grow at a much slower pace, or even contract, driving deflationary forces in the short run. On the other hand, aggressive fiscal and monetary policies by governments and central banks in developed markets potentially could push inflation to much higher levels in the long term.
“Here's an inflationary time bomb,” said Raphael Gallardo, strategist at AXA Investment Managers, Paris.
European pension executives traditionally have been more concerned about inflation because of regulatory and social pressures to tie pension payments with cost-of-living increases. However, other institutions throughout the world — including pension funds and endowments in the U.S. and sovereign wealth funds in the Middle East — are also taking a closer look at the possible effects of inflation volatility on their investment portfolios.
“Because inflation is quite low at the moment, it's hard for most (institutional) investors to envisage a scenario in which inflation will become a problem,” said Sarah Abraham, consultant and actuary at Aon Consulting, London. “But we're seeing evidence that some are beginning to worry that inflation is going to go up, but they're still not sure whether we're over the threat of deflation.”
Inflation is particularly alarming for European pension fund executives because of explicit or implicit promises to link pension payments to cost-of-living increases. In the U.K., for example, pension payments are required by law to include inflationary allowances for accruals since 1997. With some exceptions, public companies usually have a 5% ceiling for the allowances, but the limit doesn't apply to public funds and private companies.
In other European countries, there is no legal requirement to include inflationary increases but social norms dictate that pension payments should account for the rise in the cost of living, according to consultants and pension fund executives. U.S. corporations, on the other hand, usually don't include cost-of-living increases within pension benefits.