UK - Inflationary fears led to a massive deterioration in the accounting position of the UK's biggest pension funds in May, according to Aon Consulting.

The latest Aon200 Index, which measures the accounting deficit of the 200-largest DB schemes in the UK, plummeted from £8bn (€9.16bn) at the start of the month to £40bn by the month-end.

The deficit increase resulted from falls in corporate bond yields and increases in expected future inflation, said Sarah Abraham, consultant and actuary at Aon Consulting.

"The rise in projected inflation may seem counter-intuitive, given that price headline inflation (RPI) fell to -1.2% in May, the biggest drop since 1948," she said.

"However, market indicators suggest that despite the short-term deflation, a period of higher inflation is looming, and pensions accounting prices in these future projections. The effects of quantitative easing are likely to drive a period of higher inflation in the medium-term."

The Aon200 Index has been highly volatile over the past year, ranging between a surplus of £23bn last November, and a £45bn deficit in February.

Abraham said: "It is true that very high inflation would lead to pension increases being capped at the maximum level, which could improve scheme funding. However, there are indications that medium- to long-term inflation will rise to the level where it is most detrimental to pension schemes - just under the pension increase cap."

She said: "Companies can protect themselves from high inflation by ensuring that trustees have reviewed the way in which scheme assets are invested, with a view to ensuring that an inflation-linked investment return is provided."

David Fogarty, co-leader of the Mercer financial strategy group, said: "Long-term interest rates have fallen, and equity prices are now back to the levels of the beginning of the year, which are both positive for pension funds."

Fogarty said: "The third major factor is inflation. The increase in deficits may well be exaggerated because of the current high level of implied inflation within the bond and SWAP markets, which many would argue is unlikely to be borne out over the long-term."

Fogarty said that he expected long-term inflation to be in the region of 3%, the upper limit of the Bank of England's target.

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