Inflation slams U.K. corporate pension plans

U.K. corporate pension deficits nearly tripled last year — while those at U.S. corporate plans nearly halved — illustrating the sharp differences in how inflation expectations affect these plans.

While U.K. corporate defined benefit plans include limited adjustments for inflation, their U.S. counterparts typically do not peg benefits to inflation.

Aggregate FTSE 350 company defined benefit plan deficits rose to £170 billion ($272 billion) as of Dec. 31, up from £60 billion a year before, driven by a combination of higher inflation expectations and decreased corporate bond yields, according to a Mercer estimate. The estimated deficit reflected a funded ratio of 73% as of Dec. 31, down from 86% at the end of 2008.

But while U.K. companies saw up to £170 billion wiped off their balance sheets in 2009, U.S. corporate plans added $180 billion to theirs, according to a separate Mercer estimate. The aggregate deficit of S&P 1500 companies' pension plans was $229 billion, down 44% from the 2008 year-end deficit of $409 billion. U.S. plans benefited from stronger investment returns, higher equity allocations and weaker bond yield declines than their U.K. counterparts, raising the funded ratio of U.S. plans to 85% from 75% a year before, according to Mercer.

Inflation estimates “have a very big impact (on U.K. funding estimates) ... probably bigger than people realize,” said Sarah Abraham, a Manchester, England-based consultant and actuary at Aon Consulting. She noted, however, that declining corporate bond yields — which also increase pension liabilities — was the primary factor behind greater deficits in 2009. “But everybody was expecting that, whereas you don't expect to see changes in inflation. You expect inflation to be fairly steady, especially long-term inflation.”

Aon found that the 200 largest U.K. corporate plans ended the year £87 billion in the hole, down from a £10 billion surplus at year-end 2008. Higher inflation estimates accounted for £40 billion of the jump in liabilities in 2009, Ms. Abraham said.

She said the average long-term inflation assumption increased to about 3.75% as of Dec. 31 from about 3.25% a year before.

Because U.K. plan benefits are linked to inflation, companies must use real bond yields, which incorporate inflation estimates, when calculating liabilities; U.S. companies use nominal yields. Higher inflation estimates mean lower discount rates, which worsen pension funding.

In the U.K., pension benefits accrued after April 1997, including for retirees, must increase with the rate of inflation, with an annual cap of 5%. Post-2005 benefit increases are capped at 2.5% a year.

Consultants say inflation's effects on U.K. plans highlight how expensive tying pension benefits to cost-of-living increases can be.

Deborah Cooper, a principal at Mercer in London, said the effects of inflation estimates are augmented by the fact that companies report deficits, not liabilities, on their balance sheets. “The company is concerned about the difference between the liabilities and the assets,” she said. Because total liability figures tend to be huge, while deficits are much smaller, a proportionally small increase in liabilities can have a much larger effect on a plan's deficit.

Inflation expectations are the latest factor driving up estimated pension obligations, following the steep asset value declines in late 2008 and early 2009, and the decline in corporate bond yields later on last year. The growing deficits are causing U.K. companies to increase contributions, to postpone long-term plans to lower investment risk by replacing stocks with bonds, and to cut pension benefits or close or freeze defined benefit plans (Pensions & Investments, Aug. 24). Some major companies, including International Business Machines Corp., Fujitsu Ltd. and Barclays PLC, have announced plans to freeze their U.K. plans.

Multinational companies are concerned about escalating pension costs in the U.K., especially because inflation-indexing could continue to cause major liability increases even after a plan has closed or frozen its U.K. DB plan, said John Ralfe, an independent pension consultant in Nottingham, England.

However, companies are looking to cut pension costs in all the countries where they have plans, he said.

Ari Jacobs, Norwalk, Conn.-based principal and North American retirement solutions leader for Hewitt Associates LLC, added: “Inflation-linked benefits in the U.K. add another significant risk not present in most U.S. plans, which is one of the key reasons de-risking solutions such as buyouts and liability hedging are more popular in U.K.”

In the U.K., consultants note the actual impact of inflation might not be as bad as current estimates show. Estimates are based on spreads between prices of U.K. government bonds and their index-linked brethren, both of which have been distorted by quantitative easing and market factors, such as increased demand for index-linked gilts.

“At the moment, the effect of inflation is incredibly hard to call,” Mercer's Ms. Cooper said. “It's never a good measurement, but at the moment it's probably less good than normal” because of a lot of factors that could affect long-range inflation including government stimulus packages and the possible election of a Tory government in the spring, which could mean new economic policies.

Many companies take this into consideration when setting inflation estimates and will adjust their estimates accordingly. Companies shave as much as 50 basis points off inflation estimates, but an average adjustment is about 30 basis points, Ms. Cooper said.

Aon's Ms. Abraham added that very high inflation isn't necessarily bad for pension plans, even in the U.K. “If inflation becomes very high ... returns on assets should increase as well. So, inflation could be very good for pension schemes.” At the moment, however, companies must list on their balance sheets the anticipated effects of higher inflation on liabilities but cannot up assets until returns are actually made.