Inflation could push pensions back into the red

Soaring expectations of future rates of inflation threaten to wreck a recovery staged by private sector final-salary pension schemes, Aon Consulting, the actuarial adviser, warned today.

Aon said the 200 largest final-salary pension schemes in the UK, excluding public sector funds, were £6bn in surplus at the end of May, a 20 per cent improvement on last month. The figure represents a major turnaround since the beginning of the year when the same funds were £4bn short of the asset values they required to back their liabilities.

However, the dramatic improvement in scheme funding could be undermined by higher inflation, Aon warned, with expectations of inflation, based on 15-year interest rates in the gilts and index-linked bond markets, now running at 3.75 per cent.

The figure, at its highest for 10 years, is important to pension schemes because most pay benefits that rise each year with some link to inflation. Higher expectations of future inflation therefore require pension schemes to reassess the size of their liabilities, threatening to throw their funds back into deficit.

"Pension scheme surpluses have persisted for the fourth consecutive month, which is good news for companies and pension scheme members alike," said Marcus Hurd, a senior consultant at Aon. "However, the prospect of higher inflation is alarming and will be of concern to both companies and pension scheme members."

Higher expected inflation rates are likely to persuade some schemes to invest in derivatives contracts that protect them from higher benefit bills, though the cost of these is also increasing, while others may be tempted to cut back on pension increases.

Final-salary pension schemes also learned over the weekend that they are to face higher than expect bills from the Pension Protection Fund, the lifeboat fund that compensates members of schemes whose sponsoring employers go bust. The PPF said last November that it needed to raise £675m for the 2008-09 financial year, but sets premiums on the basis of how risky individual schemes are judged to be.

While the solvency of many pension schemes has increased, this will not now lead to the lower bills that sponsors might have expected, because the target figure of £675m is fixed and the funding improvements have been almost universal.