The combined deficit of defined benefit (DB) pension schemes against long-term funding targets fell by £34bn to £286bn in September, according to XPS Pension's DB:UK funding tracker, despite inflation reaching its highest level in over a decade.

The average funding level of UK DB pension schemes on a long-term funding target basis was 87 per cent as of 30 September 2021, with assets of £1,844bn and liabilities of £2,130bn.

This is despite August bringing the highest annual increase in prices since 2021, and estimations from the Bank of England’s Monetary Policy Committee that inflation will continue to rise to 4 per cent in Q4 2021.

The tracker showed that whilst rising inflation had caused a £58bn increase on the value placed on UK scheme liabilities, the 0.36 per cent increase in in gilt yields in September saw a £146bn reduction in liability values.

XPS noted, however, that the long-term inflation expectations are also increasing, with a rise of 0.14 per cent seen in September, which may be a concern for pension schemes as member benefits and pension liabilities increase.

It clarified that whilst highly hedged schemes may be largely protected, the funding position of schemes with limited inflation protection will worsen considerably, suggesting that with many pension schemes in an improved situation thanks to recent strong growth market performance, trustees should review the inflation exposure in place.

XPS senior consultant, Felix Currell, commented: “How long supply-side challenges in the global economy – examples recently in HGV driver shortages and rising energy prices – persist and the impact of further stimulus in the US will be key factors in the ongoing performance of equity markets.

“Pension schemes will be concerned about the ability of markets to keep pace if inflation reaches very high levels, particularly if interest rates are raised early to combat prevailing inflationary fears.

“Pension schemes should be exploring how they can adjust their portfolios to hedge against inflation risk. In addition, schemes may also want to consider how to protect their growth portfolios, such as by incorporating more real assets with contractual inflation-linkage.”

Adding to this, XPS senior consultant, Charlotte Jones, warned that, at the moment, the changes in market conditions have slightly shortened expectations of when schemes will meet their long-term funding targets.

"Whilst any rise in inflation will increase the value of the liabilities, most schemes will be protected from extreme rises in inflation as it is likely that any scheme benefits linked to inflation will be capped at certain levels," she said.

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