Flexibility key to managing pension burden as pensions deficits soar again

Accounting deficit of the 200 largest privately sponsored pension schemes soars by 16 bn to end the month 45 billion in the red

Aon calls for a change in attitudes to indexation which could protect schemes from the costs associated with deflation

The widening pensions accounting deficit of the 200 largest privately sponsored pension schemes, as measured by the Aon200 Index, soared by a further 16 billion in February to end the month at 45 billion, the biggest deficit in a year. Aon Consulting, the leading employee risk and benefits management firm, is urging the government to review the way in which indexation promises are implemented, to help employers to manage their pensions burden.

The movement in the deficit over the month was predominantly due to falls in equity markets. However, with little sign of recovery in the investment markets, attention is still focused on the way that changes to pension scheme benefits can impact on deficits.

As inflation falls and deflation becomes a reality, the legal requirement to increase pensions in line with inflation now represents a significant risk to employers. During a period of deflation, schemes are not able to reduce pensions that are being paid. However, once that period is over and prices come back to previous levels, schemes will be required to pay increases, leaving pensioners with a substantial increase in purchasing power and schemes with a bigger deficit.

Aon is therefore calling on the Government to consider whether legislation can be changed so that deflation can be offset against future inflation when increasing pensions in payment, in the same way that it can be done when increasing pensions between leaving and payment.

Commenting, Sarah Abraham, actuary and consultant at Aon Consulting, said: ìFlexibility over benefit structures is needed to allow employers to deal with their defined benefit pension promises. The current rules around pension increases were designed at a time when deflation was not a consideration. Although increases to deferred members allow negative inflation to offset positive inflation, increases to pensions in payment do not have this flexibility. We believe that to review the rules at this time is both a rational and proportionate response.î

Making this change would not be without its difficulties. It would mean a cut to the long-term value of membersí benefits compared to the current position, and is something that would not be popular with members, unions or pensioner groups. The change would not, however, reduce the purchasing power of pensions and Aon believes that the issue is of sufficient importance that it should at least be considered and discussed, and not be left on the ëtoo hardí pile.

Ms Abraham continued, ìThis type of change could have a substantial impact on pension obligations. Under the current legislation, schemes are effectively penalised for periods of deflation because in the long-term they are forced to give increases to pensions that are in excess of increases in inflation.

ìFor example, if we experience deflation of 1% a year and then inflation of 1% for a year, then pensions in payment will be 1% higher than today, and liabilities 1% higher, even though prices are unchanged.

ìThe cost to employers of funding these extra liabilities could be around 1bn. Clearly, if deflation persists for several years, the costs could be significant. To permit offsets would protect employers from the risk of incurring these costs as a result of long term deflation.î