Mind the Gap – the hidden cost of out-sourcing

David Davison

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I’m often asked to explain why contractors have finished up with a substantial bill payable to an LGPS at the end of an out-sourced contract. I’ve therefore compiled this very simplistic worked example to highlight the issues contractors face. The figures are for representative purposes only and are not intended to be either detailed or LGPS liability specific.

Let’s assume we had just one individual, aged 55 and on a salary of £40,000, who transitioned to an out-sourced contract for three years on 1 April 2014. The individual had been working for the Council for over 20 years, so the value of the benefits they’ve built up on an on-going (or pay-as-you-go) basis at the date of the transfer of service is valued at around £100,000. They will then have accrued additional liabilities at a rate of around £5,000 p.a. over the three year term of the contract. The Fund was only 90% funded (i.e. equivalent assets of £90,000) at the date of the transfer, so there was a shortfall of £10,000 at outset. As part of the contract negotiation, the Council agreed it would assume that the scheme was fully funded and the £90,000 actual assets were notionally viewed as £100,000. The contractor felt that this protected them from the under-funding risk.

We’re now three years down the line and the contract ended in April 2017. The total notional liabilities should be £115,000 (i.e. £100,000 + £15,000), but in reality they’ve increased as a result of a fall in bond yields over the three year period, which places a higher value on the liabilities. The liabilities are now 10% higher at £126,500 and unfortunately the asset value, including contributions paid over the three years, is still £100,000. There is now a deficit of £26,500 and the scheme is funded to around 80% on an on-going basis. Now, no-one would argue that the contractor should have to fund the liability for the period of the contract in full, i.e. the £15,000, now valued at £16,500. This, given the scheme is 80% funded would leave a shortfall of £3,300.

However, the Fund is likely to be looking for the contractor to fund the whole of the balance of £26,500, even though £23,200 of these liabilities have nothing to do with the contract, or that contractor, and were accrued prior to the contract.

In addition, the position could be worse, as if the contract came to an end and wasn’t renewed or taken over by anther contractor (who was prepared to accept the pension liabilities), the Fund could chose to look for a cessation debt. The cessation debt is calculated on a gilts basis which is very low risk – this places a higher value on the liabilities. The likely cessation liabilities could be around £180,000, leaving a shortfall of £80,000 payable by the contractor. Clearly this is only one member, so it’s not difficult to imagine what the figures may look like where many more individuals are involved.

The application of a cessation debt on a gilts basis for contractual out-sourcing is wholly inconsistent with other public sector schemes. This approach does not reflect the usually short term nature of contracting, and represents an unreasonable funding premium over the costs that could have been achieved by the contracting authority pre tender.

As if that wasn’t bad enough, if the funding position had deteriorated prior to an actuarial valuation which was happening within the three year contract period, this could result in higher contributions during the contracting period, again based on the whole of the liabilities and not just the contractors share.

In our example, as the member is aged 55, if the contractor looked to make them redundant, there would be strain on fund costs payable as the member would be entitled to their pension at normal retirement date, unreduced from age 55. The contractor would be liable in full for these costs (again unless any alternative arrangement was agreed at outset), and they could run in to tens of thousands of pounds. This is the result, despite the fact that they were only responsible for about 13% of the total liabilities. Similarly, the contractor could be responsible for ill health early retirement strain costs.

This scenario does raise some pretty pertinent questions. How can this possibly be equitable? Why should the original employer who accrued these liabilities suddenly lose responsibility for them? Equally, why would any new contractor wish to take them on knowing that they’re effectively assuming liabilities from another unconnected employer?

The answer from contracting authorities and Funds is effectively ‘caveat emptor’. If the contractor didn’t seek or achieve any form of contractual protection over these issues, then effectively that’s the deal they signed up for. Authorities and Funds have currently no obligation to explain these risks.

This highlights just how important it is to make sure that the contractual negotiation prior to agreement deals with all these issues. This process can be complex, time consuming and costly, and even then can still result in inequitable outcomes with many bidders being put off by it, resulting in poor outcomes for the contracting authority. What is also frustrating is that each local authority can adopt completely different contractual arrangements and approaches to outsourcing.

Being able to accurately allocate liabilities by employer service to more effectively deal with legacy past service benefits would greatly simplify the whole process, make it fairer and more cost effective for all, as well as being likely to produce much better outcomes for the procurer. This, in conjunction with a consistent pass through mechanism on these accrued contractual liabilities, would greatly improve the tendering process.

Contractors need to be aware of the issues and there is some good guidance available to assist. Contractors need to engage relevant professional support and be prepared to walk away if the risks are ultimately too great. Government needs to be more transparent about the risks and come up with a consistent process which can be applied UK wide.

David Davison

Post by David Davison

Specialist consultant on pensions strategy for corporate, public sector and not for profit employers

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