The pension liabilities of FTSE 350 companies could be collectively overstated or understated by up to £40bn, warns Mercer.

The financial consultant said the possible discrepancies, caused by uncertainty over inflation, shows the difficulties experienced in determining whether share price valuations effectively reflect the impact of pension liabilities.

At 31 March 2009, data analysed by Mercer showed that the long-term price inflation assumptions of FTSE 350 companies varied by 0.8 per cent, from 2.6 per cent to 3.4 per cent a year.

"There is no economist consensus on UK inflation over the next five years, let alone for the decades over which pension benefits are paid, so the difficulty is obvious," said Mercer principal Warren Singer.

"The traditional method used in the UK reflects the price of hedging against inflation risk as measured by government bond or swap markets - this is influenced by supply, demand and investor preferences and fears. Over the long-term, though, it has been a less than perfect measure. Most analysis suggests that it overstates the outlook for long-term inflation and Mercer would concur that some downward adjustment is often appropriate - however, such adjustment is subjective and is likely to vary by company."

Singer added that the consultation by the International Accounting Standards Board (IASB), expected in the next few months, could see the supervisory body requiring additional disclosures to highlight to investors the impact on pension liabilities of material risks, such as uncertain UK inflation assumptions. As a result, Mercer is recommending that companies prepare for year-end accounting disclosures and as part of this preparation reconsider the inflation assumption that is used for their pension liabilities, particularly whether inflation is being estimated over a time period that matches their plan liabilities.

"They may also wish to consider other evidence available from the Bank of England and economists in determining whether their inflation assumption should differ from a traditional market-based measure," Singer concluded.

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