James Moore: The pension funds hoping for a miracle

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The Independent Online

Outlook: One of the curiosities of the financial crisis was that it actually made final-salary pension schemes look good. Thanks to various economic quirks, they showed a funding surplus of £43bn in December 2008.

That made them a rare ray of light in a scenario of unremitting economic bleakness when almost every other indicator was saying we were going to fall off a cliff.

So now that stock markets have recovered, we should be in great shape, right? The magic market fairy that politicians, regulators and businessmen cross their fingers and pray for every time they look at pensions has waved her magic wand and everything's all right after all. Phew.

If only life were so simple. Over to HSBC's Robert Parkes who has figures that should chill the blood of any finance director – and any investor who has exposure to companies operating final-salary schemes. His analysis shows an aggregate pension funding deficit for the FTSE 350 at 26 February 2010 of £131bn. To put that frightening figure in context, it amounts to 8 per cent of index's total market capitalisation.

The problem is that the stock market's recovery doesn't help pension funds as much as you might think. Under pressure from regulators and the prevailing group-think, pension funds have been selling out of equities in favour of bonds. The selling has frequently been done at the worst possible time – when the market were at their lowest.

It gets worse. Companies work out how well schemes' assets match liabilities by taking inflation away from investment-grade corporate-bond yields. That's how you get to what Mr Parkes calls the real discount rate, the rate at which assets need to grow to meet schemes' liabilities.

The trouble is the assumptions that schemes are using to calculate inflation might just be wrong. Mr Parkes has been looking at the various graphs used by the Bank of England. His conclusion: the inflation rate is likely to be higher than people think in the coming years. Post-crisis there has been a subtle, but important, shift in emphasis from curbing inflation to protecting growth. Interest rates are likely to remain low for some time, even if the pound falls off a cliff, which it will do if the predictions of a hung Parliament come true.

That means inflation. Then there's the wildcard that could wreck even the most conservative assumptions: longevity. In its 2008 annual report, BT showed a sensitivity of £1.3bn for an additional one year increase in life-expectancy. Current projections suggest that in the next 20 years, longevity will increase by two years.

It's no surprise that schemes with the biggest potential shortfalls use the most optimistic of assumptions. They're basically hoping that the fairy comes back.