Inflation will burst equity bubble

It’s all pointing the wrong way for a route out of the pensions crisis; companies continue to grapple with pension risks, FTSE 350 pension deficit at £160 billion in Q1 2010, compared to £49 billion in Q1 2009. Increases in liabilities highlighting the significant risk attributable to inflation-linked future benefit payments, volatility prompts increased interest in de-risking.

At the end of Q1 2010, despite positive asset returns, the aggregate deficit of FTSE 350 companies stood at £160 billion – significantly higher than the £49 billion estimate reported in Q1 2009. The increase in deficit comes as pension liabilities increased on the back of falling corporate bond yields and increases in market participants’ expectations of long-term price inflation.

The data is produced by Mercer as part of its quarterly Pension Update which analyses the aggregate pension commitments of FTSE 350 companies. The previous report showed that the FTSE 350 pension deficit stood at £170 billion at the end of 2009.

“The FTSE all-share price index increased by 50 percent in the 12 months to 31 March 2010, and a lot of attention has been given to how financial markets have recovered over the past year,” commented Dr Deborah Cooper, Head of Mercer’s Retirement Resource Group. “However, the picture is more complex for companies with defined benefit pension schemes.”

“The effects of falling corporate bond yields, due to increased market confidence relative to the position last year and higher inflationary expectations, will result in many companies’ balance sheets remaining exposed to significant pension scheme deficits, despite increasing asset values,” continued Dr Cooper. “Sponsors of defined benefit plans are starting to realise the implications of a continued mismatch between the scheme’s assets and its inflation-linked liabilities. This is prompting them to consider the longer term strategic direction of their pension scheme’s funding strategy and to consider more seriously the options for reducing balance sheet volatility.”

“De-risking” strategies, such as reducing equity market exposure and buy-out, leave companies battling with the dilemma of reduced volatility but having to forego the expectation of higher returns that would result in them having to pay higher contributions. However, on the back of recent strong asset performance, many schemes are in a better position to review their funding and investment strategies, and to consider how these could develop dynamically toward their longer term objectives.

“Although risk mitigation can reduce the opportunities for highly positive market performance, it doesn’t have to remove all the upside,” continued Dr Cooper. “Offerings like Mercer’s Dynamic De-risking Solution provide a number of ways for trustees and companies to implement strategies to address pension risk issues while continuing to capitalise on market gains.”

“Events in the wider economy over the past couple of years have highlighted the need to not only be prepared for the worst, but to also have an effective strategy in place to capitalise from positive market movements when things start to recover.”

25 May 2010

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