Combined with the potential threat of inflation, decreased capital market expectations will present challenges for institutional investors. According to new research from Cerulli Associates, North American Institutional Markets 2021: Inflation’s Impact on Return and Liability-Oriented Investors, inflation’s impact varies drastically between investors that are responsible for growing intergenerational equity and investors that primarily seek to match liabilities.

The research sizes the U.S. institutional market at approximately $29 trillion, achieving growth of 7.9% in 2020. Retirement channels, including both corporate and public defined benefit (DB) and defined contribution (DC) plans, account for over two-thirds (67.9%) of total U.S. institutional market assets while insurance general accounts make up about one-quarter (25.1%) of institutional assets. Despite being a large focus for asset managers, nonprofits (endowments and foundations) make up only 7.0% of institutional assets.

Investors in 2022 will face the choice of whether to incorporate higher inflation assumptions in their portfolio construction efforts or to position their portfolios for a return to low inflation and a continuation of low rates. For nonprofits—return-oriented investors—inflation can be viewed as a tax on nominal returns, forcing these investors to target higher returns to compensate for increased inflationary costs. “Low interest rates have been positive for absolute return, risk-oriented investors such as endowments and foundations,” states James Tamposi, associate director. “As inflation increases, however, these investors will have to increase their required returns to incorporate an expected loss of purchasing power. If incremental returns do not offset inflation, these investors will rely more on long-term endowment funds to support normal operations,” he adds.

As higher interest rates will translate to higher discount rates, the effect of inflation on liability-driven investors, such as insurance general accounts, will be less severe. Tasked with managing their investments to match future liabilities, insurers surveyed prior to inflationary pressure expressed great concern about generating return/yield (81%), selecting appropriate investments from a risk-based capital perspective (47%), and asset/liability matching (33%). “The low-rate environment has presented obstacles for insurers on the asset side, as low yields mean they have had to move up the risk spectrum to match liabilities,” says Tamposi.

Many institutional investors have not had to consider inflation for over a decade and have grown accustomed to a low-rate environment. Following the recent spate of high inflation levels, investors will need to consider potential consequences for their existing portfolios as well as strategic adjustments they will need to make if this trend continues. “While both expected and unexpected inflation hamper investors’ returns, investors are able to reposition their portfolios more effectively in cases where inflation is expected,” concludes Tamposi.