Spence responds to DCLG consultation on Local Government Pension Scheme Rules with a 5 step plan for improvement

David Davison

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Local Government Pension Scheme (‘LGPS’) – Technical consultation on Local Government Pension Scheme Rules – December 2014

Introduction

The evolution of LGPS over the last number of years has created significant inconsistencies and unfairness particularly in the treatment of admitted bodies.  This is highly problematic for participants as well as building up significant difficulties for the LGPS themselves. It has also resulted in LGPS looking unresponsive to the issues that their admitted bodies face.

The consultation specifically requests “suggestions on how to better protect local tax-payers where there is a risk they will have to foot the bill for employers who leave the scheme.” LGPS need to recognise that the current approach is unfair, impractical and ultimately unsustainable. LGPS would appear to prefer to continue to pursue excessively prudent cessation settlements which are rarely if ever paid, as they are unaffordable, while organisations continue to accrue further liabilities which will remain unsettled until a point where an organisation ceases to operate and the burden is left with the tax-payer. Surely to protect the tax-payer it would be much more sustainable to find a way to prevent additional unaffordable liabilities accruing and adopt a more pragmatic methodology in calculating and obtaining any cessation liabilities due.

In this response I will therefore look to identify a number of the key issues faced and offer some proposals how the LGPS could adapt for the good of participants and themselves.

Issue 1 – Consistency of Funding Approach

There is little if any consistent practice adopted across the variety of LGPS. This makes it very difficult for admitted bodies to understand the approach which may be taken by each fund, results in arbitrary and inconsistent approaches as well as increasing advisory costs for both the LGPS and their admitted bodies.

Proposal

LGPS should adopt a uniform, transparent and consistent set of guidance for all key issues which is readily available to admitted bodies and their advisers. On out-sourced contracts all pension terms would need to be notified in advance of any contract (preferably at least 3 months in advance). This would provide cost clarity prior to agreement.

It should not be possible for admitted bodies to join LGPS without having taken independent legal advice.

Issue 2 – Calculation of Cessation Debt

LGPS is not subject to the employer exit debt regime of Section 75 of the Pensions Act 1995.  However the Fund Actuary will tend to adopt the same approach for assessing the debt due when employers exit the LGPS.

Whilst this is not surprising given the actuarial experience of using s75. Such an approach we would contend is inequitable as the design of the LGPS scheme itself does not fit well with the rationale behind the actuarial methodology and policy intentions that created s75.

The rationale for the S75 calculation is that the benefits will be secured (with an insurance company) and therefore are calculated on a least risk basis equivalent to an insurer’s reserving requirements. This is never going to be the case within an LGPS as the benefits will continue to be provided from the Fund.  A Fund is unlikely ever to be wound-up via the insurance route which underpins the S75 methodology.

In short, the level of Exit Debt often sought by LGPS Funds is therefore only being used to effectively subsidise other employers remaining in the Fund.

In addition, LGPS tend to enforce very short payment terms to settle an exit debt. Should an organisation run out of active members (for example on coming to an end of a contract), it will trigger its exit debt. This approach leaves participants forced to continue in a scheme (if possible) beyond the point at which they can afford the liabilities accrued as they are unable to afford to settle an exit debt. This cannot be in the members, organisations, other participating organisations or the Funds interests. LGPS has chosen to historically take a pretty ‘laissez faire’ attitude to admitted bodies continuing to build up liabilities well beyond the point of reasonable affordability. Recent valuations have then seen a change of approach with Funds then looking to pursue significant additional contributions (often 2-3 times multiples) well beyond what is affordable to the admitted bodies.

Proposal

There is a recognition that an LGPS needs to adopt a margin for prudence on an employer exiting to ensure that those organisations remaining have limited risk of being required to pick up liabilities on behalf of another organisation. However, adopting a gilts based cessation basis is excessive given benefits are not being secured and as the admitted bodies assets post cessation are not being invested in a gilts based strategy to de-risk this is a totally unreasonable approach. A more realistic scheme orientated basis should be adopted e.g. adjusted rate based upon the discount rate applied in the LGPS on-going funding valuation plus a discontinuance margin.

The Fund should seek to re-coup any deficit up to the on-going level over as short a period as practically possible however with any agreed ‘margin payment’ due paid over the medium to long term based upon affordability or if additional security is offered in lieu of the debt payment.

Organisations should be able to cease to accrue liabilities without automatically triggering a cessation debt. The funding could be adjusted to reflect the closed basis of the scheme and repayments made over time on a basis similar to that outlined above. The payments could also be flexed based upon covenant strength and/or availability of security.

This more balanced approach is likely to be cash neutral for schemes as it will result in fewer insolvencies where very limited funds (if any) are recovered and be more likely to recoup funds to at least an on-going funding basis. It will also make it easier for organisations to cease further accrual more easily and at a more affordable level again reducing risk exposure to the Funds.

We would therefore propose that:-

(i) statutory guidance on the basis of calculating LGPS exit debts is issued, or

(ii) firm guidance from the Department of Communities and Local Government on actuarial behaviour and approach to cessation valuations under the Regs

The key point is that the Regulations are flexible enough to allow for both an exit debt to be calculated and imposed on an on-going basis and also for the debt to be paid over time.  It is just mainstream DB Occupational Pension Scheme conditioning, and not the law, that is dictating the current approach.  Indeed the current approach is not immune to a challenge.

Funds should also look to provide more flexibility for admitted bodies to pre-fund exits.

Issue 3 – Allocation of Liabilities

LGPS adopts an approach of allocating all scheme liabilities (active, deferred and pensioner) to the last employer to employ members in a scheme. This is inconsistent with usual market practice and can have significant consequences for charities operating as community admission bodies (“CAB”) under LGPS[1].

A CAB employing staff in LGPS at outset will have a notional calculation made which will usually allocate 100% of the assets and liabilities on an on-going scheme funding (“On-going”) basis[2] for each employee[3]. This means that the employer becomes liable for not only the future service but all past service liabilities accrued up to the date of transfer.

Experience which is different to that assumed for the purposes of the initial liability valuation (for example lower than expected investment returns or higher than expected inflation), or revisions to the way in which the assumptions are set, will affect the full past service liabilities, not just the benefits that are built up for employees of the CAB whilst they have been employed by the CAB.  Normal practice would dictate that any deficit arising as a result of these changes becomes the responsibility of the CAB and they would have to make good this deficit via increases to contributions.

Whilst the liability initially may be 100% funded on an on-going basis, it is not fully funded on an exit basis. The exit debt would again be based not just on service accrued whilst employed by the CAB but on all accrued service (i.e. including service accrued prior to being employed by the CAB). This means that organisations can have very significant exit debts (often well in excess of the value of the organisation) within a very short period of participation. This presents a significant risk to the organisation and also limits their options in terms of scheme exit – it becomes a barrier to exit.


[1] This also applies to Transferee Admission Bodies.

[2] Note that there is no prescribed basis under the LGPS legislation.  Instead the onus is on actuarial discretion.  This is usually manifested through the Funds Funding Strategy Statement which is a key document and is a collaborative approach between Fund and actuary albeit that employer’s are ‘consulted’.

[3] Note that this may not always be the case but is the prevalent approach.

In addition, the new employer becomes responsible for ‘strain on fund’ costs related to the employees full period of service and not the period of employment with the charity. ‘Strain’ costs would include the additional costs associated with a staff member being removed on grounds of ‘operational efficiency’ (such as redundancy) and the provision of an undiscounted early retirement pension as a result. These again can represent very significant costs which can be disproportionately allocated to the last employer.

Proposal

LGPS should segment liabilities based upon the service period with each organisation with the latest organisation only responsible for the service period of its employees and the continued salary link on past service liabilities. This would be consistent with other multi-employer schemes. Strain costs would also only be based upon service with that employer and prior costs apportioned appropriately.

All public sector out-sourced contracts should be established on a ‘pass-through’ basis to provide greater clarity and certainty. Such an approach should also encourage greater participation from tenders which should be beneficial to the public purse.

Issue 4 – Abolition of Defined Benefit Contracting-Out

The abolition of contracting-out in 2016 will result in a significant increase in participation costs. There is also a significant risk for low earners with the introduction of the new single tier state pension that members could become ‘over provisioned’.

Proposal

Employers should be permitted to reduce benefits or increase member contributions proportionately in accordance with the increased cost in National Insurance.

Issue 5 – Pension Flexibility

With greater flexibilities now available to individuals post the 2014 Budget changes it is clear that a scheme which purely provides DB benefits is no longer suitable for all staff, especially with the introduction of auto-enrolment. Indeed many DB Schemes have sought to manage the issue of liabilities growing beyond an affordable level by offering employers access to a DC option within a multi-employer scheme. Such an approach could also deal with additional voluntary contributions (AVCs).

Proposal

Implement a DC option within LGPS either via a new DC scheme being made available or via the integration of the Scheme with an existing auto-enrolment solution.

 

David Davison

Post by David Davison

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

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