Author Details

Monika Szikszai

Monika Szikszai

Associate, MSCI Research

Thomas Verbraken

Thomas Verbraken

Executive Director, MSCI Research

Puneet Kumar

Puneet Kumar

Executive Director, MSCI Research

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How Might Inflation Impact Funding Ratios?

  • We looked at hypothetical optimistic and pessimistic multiyear inflation scenarios and assessed the additional contributions a defined-benefit pension fund would have to make in case a funding shortfall arose.
  • We saw that during our 10-year-long stagflation scenario, special contributions could shorten the funding ratio’s recovery by several years.
  • In our stagflation scenario, these special contributions — invested during the market downturn and subsequent recovery — experienced higher-than-average returns compared to assets invested over the full period.

Inflation is rising — with the U.S. consumer price index up 5.4% compared to June last year — and driving market performance. But inflation also has implications for defined-benefit (DB) pension funds, whose funding ratios are affected by changes in assets and liabilities. We analyzed two multiperiod inflation scenarios to understand how funding ratios could evolve in each and what it could mean for the pension fund in terms of special contributions over the next 10 years. We found that, under our hypothetical Stagflation scenario, the funds would need to make special contributions in the first six years to improve their funding status.


The Process

Our analysis concentrated on DB pension funds that aim to keep their funding ratios around 100%. In our example, we specifically addressed the case of a hypothetical Canadian pension fund’s having to comply with Canadian regulations requiring federal private pension funds to pay special contributions in case of a funding shortfall.1 The asset side of our Canadian pension fund has an allocation to global equities, Canadian bonds, Canadian and U.S. real estate and global infrastructure (see exhibit below). We proxy the liability side with a hypothetical cash-flow projection of an open pension fund and assume the liabilities are indexed to inflation.2


Asset Allocation of Our Hypothetical Canadian DB Pension Fund

The allocation to global equities was proxied by various MSCI Indexes, Canadian real estate by MSCI/REALPAC Canada Quarterly Property Fund Index, U.S. real estate by MSCI U.S. Annual Property Index, Canadian bonds by various Bank of Montreal ETFs and MSCI Corporate Bond Indexes and global infrastructure by the MSCI ACWI Infrastructure Index.

We looked at the hypothetical fund’s return under two 10-year multiperiod scenarios for inflation.3 First, an optimistic “Reflation” scenario (strong economic growth, inflation slightly higher than central-bank targets and a strong equity market) and, second, a more pessimistic “Stagflation” scenario (slowing economic growth, high inflation and an equity-market downturn).4 We assumed yearly rebalancing to the original asset allocation and reinvestment of income. Whenever the pension fund needed to make special contributions because of a funding shortfall, we assumed proportional investment into the asset mix.


The Results

Under the Reflation scenario, the funding ratio remained relatively stable and above 100%, as both the assets and liabilities gained value, and no special contributions were required. In the Stagflation scenario, however, the funding ratio dropped below 85% at the end of the second year and special contributions were triggered at the beginning of that year. Four years after the market bottom, the funding ratio recovered to 100% thanks to the special contributions. Without special contributions, it would have taken 10 years for the funding ratio to recover to that level (see exhibit below).


Stark Differences Between the Two Scenarios


Impact of two inflation scenarios on a hypothetical DB pension fund’s assets (blue), liabilities (yellow), funding ratio (red) and special contributions (gray bars). For the Stagflation scenario, the dotted line reflects the assets or funding ratio in the case where no special contributions are made to the fund.

We also saw that imposing the discipline to make special contributions immediately after a shortfall arises had another benefit. In our Stagflation scenario, the pension fund made special contributions when markets were down or in the early stages of recovery. The exhibit below shows that the annualized return on these special contributions was higher than the average return over the full period. In other words, the mechanism of special contributions resulted in new investments at beneficial times.5


Special Contributions Made a Difference


Average annualized holding period return for a Canadian dollar invested in a specific year during the Stagflation scenario and held until the end of the scenario period.

Depending on the type of inflation scenario, our DB pension fund’s funding ratio remained relatively flat or experienced a significant drop. Special contributions played an important role in the latter case, by pushing forward the funding ratio’s eventual recovery by several years.



1To calculate special contributions, we took the running 3-year average of the funding shortfall and funded that shortfall over the next five years through equal payments, as described in the regulation “Preparation of Actuarial Reports for Defined Benefit Pension Plans” by the Office of the Superintendent of Financial Institutions.

2As the hypothetical pension fund is open to new participants, the cash-flow projection increases in the first few decades and then starts to decrease. The duration of the hypothetical pension-fund liability is around 35 years. We do not assume a cap to the inflation adjustment.

3We used the MSCI Multi-Period Stress Testing tool for propagating the multiperiod shocks to the asset portfolio. The Multi-Period Stress Testing methodology accounts for the reinvestment of income, rolling into constant-maturity bonds and rebalancing each quarter to the target asset allocation.

4The initial inflation shock is based on the narratives outlined in previous MSCI research, while over the 10-year horizon inflation reverts to its long-term average. In the Stagflation scenario, 10-year U.S. breakeven inflation rises to 5.45% over four years before it slowly reverts, while the 10-year U.S. government bond yield follows suit and U.S. equities lose around 32% in the first year. In the Reflation scenario, 10-year U.S. breakeven inflation rises to 2.9% in the first two years, while nominal yields remain flat and U.S. equities grow steadily with around 4% annual gains.

5While the Stagflation scenario is hypothetical, prior MSCI research highlighted that, over the past 50 years, markets typically recovered within a five-year period.



Further Reading

Stress Testing Multiperiod Inflation Scenarios

How Inflation Could Affect Multi-Asset-Class Portfolios

Long-Horizon Risk: The Past 50 Years

MSCI Perspectives podcast: What’s Up with Inflation?

Insights Gallery: Government-Bond Yields and Inflation