LGPS 2019 valuation to see new pressures on affordability

“The good news is you're really good at investing,” the head of pensions at the Local Government Association and secretary to the LGPS scheme advisory board tells the audience at a Pensions Expert Forum.

Indeed, LGPS asset values have almost doubled in less than a decade, increasing from £141.6bn in 2010 to £275bn at the time of the scheme’s 2018 annual report. While contributions also play a part, over the 2017-18 reporting period the majority of this increase came from investment.

Future funding costs are probably going to increase again

David Davison, Spence & Partners

Couple that with improvements in life expectancy occurring slower than actuaries had predicted, and you should have the recipe for a shrinking deficit. However, the bad news Mr Houston brings concerns the cost of future service in the LGPS, with lower investment returns and multibillion increases to annual liabilities set to have a significant impact.

“Because you’ve had really good performance, there’s less chance of getting even more good performance,” he says, relaying analysis by actuaries Barnett Waddingham.

“In the future, maybe we need to be slightly more prudent on the kind of performance we might see.

“It probably comes down to deficits reducing, because we’ve had that good performance and we are not going to be paying those pensions as long as we thought we might be. But in terms of future service we might be looking to be slightly more prudent.”

Legal cases could add billions to liabilities

The extent to which these movements will offset one another – and their impact on employers in the short term – is unclear, with the 2019 valuation still being finalised. But regardless of whether deficits shrink at this valuation, there will be a number of headaches concerning LGPS stakeholders when it comes to funding the scheme for the future.

In particular, several legal cases threaten to materially increase liabilities in the future. The Government Actuary’s Department estimates that the impact of the McCloud case alone – where protections from pension cuts for senior judges and firefighters were ruled discriminatory – could add around £4bn a year to LGPS liabilities, according to Mr Houston. Negotiations between the Treasury, unions and other stakeholders to find a solution have not yet begun.

“All public service pension schemes have erred under law by giving protection to certain individuals, and we’ve got to do something about it,” he says.

“We don’t know when we’re going to know what the remedy will be, we don’t know what the remedy will be, and we don’t know what the remedy will cost.”

A further unknown is how this remedy will interact with the cost cap designed both to protect employer costs and, crucially, to uplift member benefits if the LGPS is not generous enough. The government has shelved the cap until the outcome of the McCloud judgment is clear.

“That potentially costs us about another 1, 1.5 per cent of employer contributions depending on what happens on McCloud,” says Mr Houston.

“If McCloud costs more than cost cap, we don’t do cost cap; if McCloud costs less than the cost cap, we have to do a bit of cost cap; if McCloud doesn’t cost anything, we have to do all of cost cap.”

Mr Houston says that the potential increases in cost could motivate some in government to want to further water down the benefits provided by the LGPS, necessitating a robust response from local authorities to show they are managing risks well.

"We have to continue to make the case for public service pensions, we have to continue to make the case that in the LGPS we are effectively doing this. So all of that stuff I just talked about in terms of your valuations, in terms of the unknowns, we need to make sure that when you do your valuations that is recognised in there, even though we don't know what half of it's going to cost," he says.

Private sector participants under pressure

While local authorities may be able to absorb the impact of adverse legal rulings and deteriorating return expectations, admitted bodies – non-council employers who pay into the scheme for their own staff – could struggle with these costs.

“Future funding costs are probably going to increase again,” says David Davison, a director and owner of Spence & Partners, who leads its public sector, charity and not-for-profit practice.

“For some of the admitted bodies it could be really material.”

Affordability issues for these employers are further complicated by the threat of triggering a cessation debt if they leave the scheme. A government consultation that closed in July floated arrangement akin to the deferred debt option now available to participants in other multi-employer schemes for those with a sufficiently strong covenant, but Mr Davison says many find they are still in a bind.

“[The LGPS partner funds] are just using it as an excuse to extract security out of organisations, and if the organisations don’t have the security then any change in the regulations doesn’t work,” he explains, adding that there is a potential “tidal wave” of such employers who would like to exit but can’t.

In March, a charity in Northern Ireland announced its closure, blaming pension costs and a lack of flexibility.

Mr Davison says the LGPS has become a two-tier system, where local authorities run investment risk and maintain affordability, but admitted bodies with shakier covenants see a high cost to both staying in and leaving.

“Using gilt-based exit yields is making the schemes an absolute fortune, because most of the schemes are still investing in the same way [as before],” he says.

Derisking trend could spread to LGPS

While increasing costs of funding have all but killed off defined benefit in the private sector, the strong covenant behind local authority schemes has allowed them to be more resilient.

With a theoretically unlimited ability to access cash from tax revenue, public sector employers are unlikely to become insolvent in the same way as a private sponsor, and as such have tended to take investment risk to fill funding gaps, assuming that they can ride out volatility – the average LGPS allocation to equities stood at 55 per cent last year.

However, some local authorities are experiencing another phenomenon new to private sector DB schemes. “Although the LGPS as a whole is cash flow positive, there are funds that are now cash flow negative,” says Mr Houston, adding that some partner funds are now rebalancing their portfolios in favour of income generation over growth.

From a theoretical standpoint, this derisking could be sensible if asset returns are to remain low for a long time, says Nicholas Barr, professor of public economics at the London School of Economics.

“There’s an old distinction between risk and uncertainty... with risk you know the probability distribution of future outcomes with reasonable precision and you can smooth reasonably well. With uncertainty you know there’s a distribution but you don’t have a clue what it is,” he says.

Some uncertainties can be addressed for LGPS partner funds, for example by hedging inflation and longevity, Mr Barr says, but adds that for schemes to continue to take risk amid potential long-term declines, government may have to consider flexibility on benefits as a pressure valve – as happens with some Canadian DB plans.

“There’s an inherent problem that if you try and smooth, and there’s uncertainty and you face a long-term downward trend, let’s say if asset returns go down over the long term, then you end up dumping on future cohorts. And since risk sharing is good, I find that conclusion deeply uncomfortable,” he adds.