UK - Companies are increasingly turning to derivatives to protect scheme funding levels against inflation risk, even though the top 200 private sector defined benefit (DB) schemes generated surpluses worth £6bn in May, Aon Consulting has revealed.

Latest figures from the monthly Aon200 Index show there was an increase in the aggregated surplus of the top 200 private sector schemes in the UK of £1bn in May, from £5bn in April to £6bn at the end of May.

It is the fourth month in a row that schemes have reported an aggregate surplus, and it represents just a small increase in values but is significantly better than the 50% drop of surplus assets seen in April, when assets moved from a surplus of £10bn at the end of March 2008 to just £5bn.

This research therefore indicates 56% of the DB schemes surveyed now remain in surplus on an IAS19 basis.

However, the consulting firm also revealed while schemes have improved their funding positions, inflation has increased significantly over the last two years, with expected inflation now reaching a 10-year high of more than 3.75%, based on figures from the Bank of England.

Aon claimed the fluctuating inflation rates could cause problems for employers as it can result in"unwelcome variations in pension scheme funding levels" as scheme benefits are often linked to inflation.

To try and offset changes in inflation, the firm said companies are likely to use inflation hedging derivatives, which "transform the nature of pension scheme assets" to more closely match the inflation exposure of the scheme benefits that are payable as part of their liability-driven investments (LDI).

Marcus Hurd, senior consultant and actuary at Aon Consulting, said: "Companies are increasingly looking towards derivative solutions for hedging inflation risk. The prospect of higher inflation is alarming and will be of concern to both companies and pension scheme members."

However, the continued improvement in the funding position of DB schemes is supported by the most recent figures from the Pension Protection Fund's (PPF) 7800 Index which showed the total aggregate surplus had increased from a deficit of £23.6bn at the end of March to a surplus of £30.3bn at the end of April 2008. (See earlier IPE story: PPF index hits first surplus of 2008)