If British companies burdened with financial uncertainty presented by defined benefit (DB) pension schemes needed reason to consider the buyout option, it was provided in spectacular fashion in May.
Among the top 200 companies, Aon Consulting, a unit of insurance broker and risk management service provider Aon, estimates that the combined DB pensions accounting deficit soared from £8 billion ($13 billion) at the start of the month to £40 billion by month-end.
Driving the increase were falls in corporate bond yields and increases in expected future inflation which dwarfed the benefit of the equity market’s gains during the month.
“Economists are debating the problems associated with deflation but for pensions schemes, we are switching our concerns to the spectre of looming high inflation,” said Sarah Abraham, consultant and actuary at Aon Consulting.
While Aon’s concerns are not shared by all, there is clearly a great deal of uncertainty in the market.
Indicatively, in its May inflation outlook the Bank of England (BOE) noted: “It is more likely than not that CPI inflation will be below the 2 percent inflation target in the medium term. But there are significant risks to the inflation outlook in each direction.”
This is reflected in the BOE’s forecast of consumer price inflation in the first quarter of 2012, which ranges between a low of minus 0.5 percent and a high of plus 3.5 percent. Aon put the impact of a change in the inflationary input into DB fund liability calculations.
“For example, if inflation were to rise by 1 percent and there is not a corresponding increase in the investment return achieved, the accounting deficit might rise by around £85 billion,” said Abraham.
She conceded that very high inflation would lead to annual pension increases being capped at their maximum level – typically 5 percent – which could improve scheme funding.
“However, there are indications that medium- to long-term inflation will rise to the level where it is most detrimental to pension schemes – just under the pension increase cap,” she warned.