With inflation running at levels we have not seen for the last 40 years, many of my clients are questioning the benefit of waiting to obtain a CETV, hoping that the increased inflation will have a positive affect on the CETV values. Before we explore this, it is important for us to understand the relationship between inflation and interest rates.
Inflation is increased when there is an increased demand on supplies, and supplies are maintained at their current level, and/or increased by a lower degree than the increase in demand. An increase in demand will increase prices and this leads to inflation. Most central banks have a target inflation rate of 2% per annum and inflation above this will be “reigned in” by central banks increasing the interest rates. By increasing the interest rates, borrowing becomes more expensive and this reduces the demand. A reduction in demand will result in a reduction of prices and hence inflation will cool off.
Both inflation and interest rates have a relationship on the CETV as provided by defined benefit pension schemes. Inflation has a positive relationship on the CETV value (i.e. an increase in inflation has an increase in the CETV value); whereas (which is a little less known), interest rates have a negative relationship on CETV values.
Owing to the fact that interest rates are increased when inflation is high, members of defined benefit schemes find themselves in the unenviable position where one variable increases the CETV, whilst the other reduces it. Therefore, the vital question is which one of these variables has a larger affect on the CETV.
To answer, this we need to understand how the CETV is calculated. For a detailed description please visit this blog post. Let’s assume a person works for 30 years, with a final salary of £50,000 and the scheme has an accrual rate of 1/60th. Using a 2% inflation, a 3% gilt rate, a 4% discount rate and 10 years until retirement, we can see that the CETV would compute to £686,257.46.
If we were to increase the inflation rate by 1%, this would result in the CETV increasing to £756,584.79. This is a 10.25% increase in the CETV.
By increasing the gilt rate (interest rates), also by a single percentage point, we can see that the CETV decreases from £686,257.46 to £514,693.10. This is a 24.99% reduction in the CETV.
Therefore we can conclude that a single percentage increase in interest rates, has a negative effect on the CETV of more than double a similar single percentage increase in the inflation rates.
Furthermore, by increasing both inflation and interest rates by a single percentage point, the CETV reduces from the original £686,257.46 to £567,438.59; a reduction of 17.31%.
By keeping all the data static we can clearly ascertain that movements in interest rates have a larger (negative) effect on the CETV than a similar movement in inflation would have.
To conclude therefore, it would be detrimental to postpone obtaining a CETV under the impression that higher inflation would increase this in the future, as interest rates would also be increasing to counter inflation and this has a larger affect on the CETV.
If you would like to download a free CETV calculator, please use this link and you can amend the variables to ascertain the degree to which each affects the CETV.
Naturally, should you wish to discuss this in more detail and how this may be affecting you, please feel free to get in touch.
Peter Button Llb MSc DipFA 