Inflation Assumptions Under the Spotlight

Getting estimates of inflation wrong can have disastrous effects on your deficit levels, but which pension funds were most off target in the last decade?

(October 4, 2013) – The average US public pension fund got its estimates of inflation levels wrong by a differential of 1.13 percentage points between 2001 and 2008, a white paper has shown.

The worst-calculated assumptions took place in 2002, when the average inflation assumption was 2.24% out.

Examples of plans that have used assumptions on the upper end of the sample include: the Arizona Public Safety Personnel Retirement System (5% to 5.5% for all of the years analyzed); Duluth Teachers Retirement Fund (4.5% to 5% for all of the years analyzed); and the Alabama Employees’ Retirement System (4.5% for all of the years analysed).

At the other end of the scale, examples of plans that have used assumptions on the lower end of the sample include: State Universities Retirement System of Illinois (1.25% to 1.5% for all of the years analysed); New York City Employees Retirement System (2.5% for all of the years analyzed); and California Public Employees' Retirement System (3% to 3.5% for all of the years analysed).

Pension funds outside of the US fared a little better. Ontario Pension Board in Canada had an average assumed inflation rate of 2.54% between 2002-2011, compared to the actual average inflation in Canada of 2.07%.

In Ireland, public service pensions in the are administered by the National Pensions Reserve Fund (NPRF), which built in an annual inflation assumption benchmark of 2.1%, according to its 2011 Annual Report and Financial Statements.

Between 2001 and 2011, the World Bank reported that the average inflation in Ireland for this time period was 2.29%, or about a fifth of a percentage point above the rate assumed by NPRF.

Now the challenge is to try and predict where inflation will head next, the paper said.

“Several central banks and the IMF project longer-term inflation to be approximately 2% in their forecasts. Going forward, it will be important to see how close these forecasts match actual inflation and, relatedly, how close actual inflation aligns with the assumptions used by pension plans in developed nations,” the paper continued.

“Also, more particularly, for developed countries experiencing increased inflationary pressures for the first time in decades, such as the UK over the past three years, it will be important to study the adverse impacts on the purchasing power of salaries and pension benefits and how public retirement schemes can adjust to such circumstances.”

The full paper, written by Alex Brown, M. Nicolas Firzli, and Joshua M. Franzel, can be read here.

Related Content: Why We’ve Not Seen the Back of QE (and Why We’re Not in Recovery Mode) and The Inflation Hedge Myth  

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