Volatile inflation rocks pension deficits |
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| Strategic Finance | |
| Written by Catherine Murray and Aon Consulting | |
| Friday, 29 May 2009 | |
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Companies should ensure they hold an appropriate mix of pension scheme assets to mitigate the risks associated with high inflation Despite sustained gains in the financial markets, the accounting position for Britain’s final salary pension schemes suffered a huge fall in May, according to Aon Consulting. Projections of rising inflation are one of the chief causes for the swelling deficit, nullifying asset gains, says the employee risk and benefits management firm. The pensions accounting deficit of the 200 largest privately sponsored pension schemes, as measured by the Aon200 Index, increased massively during May, from £8bn at the start of the month to £40bn. The deficit increase results from falls in corporate bond yields and increases in expected future inflation. These factors increase the expected cost of providing pension benefits and so offset the improvement in the equity markets gained during the month. The rise in projected inflation may seem counterintuitive given that price headline inflation (RPI) fell to -1.2 per cent in May, the biggest drop since 1948. However, market indicators suggest that despite the short term deflation, a period of higher inflation is looming and pensions accounting prices in these future projections. The effects of quantitative easing are likely to drive a period of higher inflation in the medium term. The inflation headache for scheme membersFor members of defined benefit (DB) pension schemes, high inflation may pose a big problem because the vast majority of schemes cap the increase, typically at 5% per year 2.5% per year. So if inflation is very high, the purchasing power of individuals’ pensions is eroded. Worse still, some pensions that were earned before 1997 do not receive any increases in payment. For these members, any rises in prices are bad news and high inflation will exacerbate the problem. For example, if inflation rose to 4% then some people would effectively see a 4% fall in the amount of goods they could buy with their pension. The inflation headache for pension scheme sponsorsUnless pension schemes have taken action to protect themselves, higher inflation may lead to increased pension scheme deficits and heavier funding burdens for companies. Increased inflation pushes up the cost of providing the scheme. To balance this, extra money needs to come in – either from better returns on the scheme assets or from additional contributions from the sponsor. In the long term, assets should provide a better return when inflation is high, but there is a risk that this does not bear out in practice. This is particularly the case in the short term and is a concern for schemes that hold assets which do not provide an inflation linked return – for example, government bonds or corporate bonds that provide a fixed coupon and redemption payment. Sarah Abraham, consultant and actuary at Aon Consulting comments, "Economists are debating the problems associated with deflation but for pensions schemes, we are switching our concerns to of the spectre of looming high inflation." "Pensioners may be concerned by possible falls in the “real” value of their income and unfortunately, those who have the least protection – those who retired some time ago before legislation came into effect to require pensions to increase in line with inflation – are likely to be the most vulnerable," says Abraham. Abraham explains that companies may also feel the effects of higher inflation. "It is true that very high inflation would lead to pension increases being capped at their maximum level – 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 says. There is a real risk for sponsors that this level of inflation would have an adverse effect on their schemes, Abraham explains. For example, if inflation were to rise by 1% and there is not a corresponding increase in the investment return achieved, the accounting deficit might rise by around £85bn, she says. "Companies can protect themselves from high inflation by ensuring that the Trustees have reviewed the way in which scheme assets are invested, with a view to ensuring that an inflation linked investment return is provided," says Abraham. |
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