A £40bn problem could get far worse

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.