An increase in UK long-term inflation expectations has seen defined benefit (DB) schemes suffer a decrease in funding levels despite strong equity growth over 2013.

Research from Mercer showed the IAS19 accounting deficits for FTSE 350 firms increase by £25bn (€30bn), reaching £97bn by the end of December.

The consultant’s monthly Pension Risk Survey showed that while funding levels worsened over the year as a whole, the end situation was an improvement on the £102bn deficit level a month previous.

The research said the deficit growth, driven by inflation expectations, came despite a 19% return from UK equities and significant cash contributions from sponsoring employers.

However, Mercer pointed out that, even though IAS19 deficits increased for pension funds, actuarial valuation deficits and those measured on a buyout basis both showed an improving picture.

Ali Tayyebi, head of DB risk at Mercer, said the IAS19 funding level drop demonstrated the three key elements that influence deficits over the year.

“Deficits increased sharply up to the end of April driven largely by increases in the market’s outlook for long-term market implied retail prices index (RPI) inflation,” he said.

The rise in expectations during the first quarter came after the shock announcement from the UK Office for National Statistics (ONS) that it would not amend its calculation method for RPI.

This came after markets already accounted for a change in its calculation, making it more akin to the generally lower consumer prices index (CPI).

“The position had recovered by mid-year as corporate bond yields increased sharply over Q2, reducing the value placed on pension scheme liabilities,” Tayyebi added.

“However, a further increase in long-term market-implied inflation and a reversal in corporate bond yields increased deficits by £20bn over the second half of the year, despite the UK stock market returning 10% over that period.”

Adrian Hartshorn, senior partner in Mercer’s Financial Strategy group, said that, despite the growing IAS19 deficit, improving outlooks in actuarial and buyout deficits boosted the demand for risk-reduction exercises, making 2013 a record year for insurance contracts.

“There are also likely to be other transactions and exercises implemented by scheme sponsors, such as options that allow pensioners and deferred pensioners additional flexibility in the way they draw their benefits,” he said.