Inflation Risk Is Different for DB and DC Plans

According to the white paper “Keepin’ it Real: Inflation Risk as an Asset Allocation Problem,” from J.P. Morgan Asset Management, defined benefit (DB) and defined contribution (DC) plans are affected differently by inflation.

Maddi Dessner, client portfolio management executive director at J.P. Morgan Asset Management and co-author of the white paper, explained to PLANADVISER: “DB plans are, in a sense, exposed largely to their liabilities. As their liabilities increase, their funded ratios decrease. Now due to the fact that inflation expectations are incorporated into long-term and medium-term interest rates, rising interest rates can be a good thing. DB plans can look at inflation as a positive development.”

On the other hand, DC plans are contributed by individual participants, and have a different effect from inflation. “It’s very much deteriorating purchasing power that participants need to protect against,” said Dessner. She adds that investors are affected the most by inflation in the last 10 years before retirement. “When you get into those shorter time horizons, participants are exposed to inflation. So it is in those shorter periods that participants need to put allocation into inflation-sensitive asset classes.” 

Preparing for Inflation Risk 

Institutions tend to address inflation risk by adding inflation-sensitive or real assets only when inflation is already on the rise. However, Dessner recommends that investors evaluate what their specific exposure to inflation is. “Each organization is exposed to components to inflation and inflation at different points,” she said. “It makes sense to create a basket of inflation-sensitive asset classes…it’s important to build a diversified basket to help to protect from those deteriorating effects."

According to the white paper, there are three key issues for investors to keep in mind when preparing to beat inflation over the long term:

•  Inflation spikes are, in historical terms, relatively rare. Inflation typically remains contained, interrupted by a short bust of moderate inflation.

•  Every asset has unique inflation-cycle sensitivities, meaning that returns typically vary, depending on whether inflation is high or low, or rising or falling.

•  Asset returns can also be driven by independent factors, such as asset bubbles and bear markets, that can occur in connection with, or independent of, the inflationary environment. Therefore, overweighting a portfolio with a single allocation to an asset that is designed to manage risks tied to a specific inflationary scenario could create significant problems later as the portfolio encounters other inflationary cycles and economic regimes.

Investors should also customize their inflation-protection strategy based on their individual objectives and time horizons, which can, in turn, be used to determine the parts of the inflationary cycle that pose the greatest threat to them.

Key White Paper Findings 

According to J.P. Morgan Asset Management, there are five key findings that the white paper’s authors found during this analysis of data. The findings include:

1. Cyclicality: Inflation tends to move in cycles. Empirical evidence suggests that there are small, episodic periods of rising or falling inflation marked by larger regime shifts.
2. Inflation shocks are not the biggest risk to portfolio returns: Data indicated that the most common inflation risk scenario is the period of low inflation combined with a bear market, resulting in negative real returns. The risk of negative real returns happens most commonly during periods of low inflation, not high inflation.
3. Insurance against unexpected inflation: In the long run, an asset’s unexpected return will have inflation expectations embedded in it, paying the investor a premium for bearing that risk. However, inflation risk is also the risk of short-term unexpected inflation that is not compensated by the embedded premium. Investors can anticipate and protect against such risks, but must understand that every insurance policy has a cost during those times when the hedge is on, but inflation is not.
4. Every asset comes with risks: Similarly, every inflation-protection strategy carries with it specific asset class risks. Because narrow solutions do not work consistently, the paper’s authors believe there is no such thing as a silver bullet. Inflation-protection strategies should be diversified and designed within the context of the investor’s total objective. Only in this way can one gain inflation protection without compromising the portfolio’s other goals, such as liquidity, return targets and volatility constraints.
5. Narrow solutions are inappropriate: A single, simplistic inflation-protection strategy cannot account for all of the variables in inflation risk, such as the cyclicality of inflation regimes, its correlation (or lack of) to the business cycle, the wide variance in asset performance under different inflationary regimes and the potential costs of adding inflation protection at the wrong time.

Other authors of the paper include Katherine Santiago, research and analytics vice president and Joseph Simonian, Ph.D., research and analytics vice president, both with J.P. Morgan Asset Management.

Click here to view the white paper in its entirety.