Falling equity values and the continuing commitment to a defined benefit scheme have combined to turn local government pension schemes (LGPS) into a landscape of black holes.
The chickens well and truly come home to roost as at 31 March this year, when the next tri-annual valuations take place.
The last pension scheme valuations, in 2001, showed a total deficit of £10bn (E14.3bn). This is forecast to rise to £30bn in March, when around 90 funds in England and Wales will be valued.
Chris Hull, head of the local government consulting unit, Mercer Human Resources Consulting, says: “Local authority funds typically have an equity-based investment strategy, so their valuations have obviously fallen over the past few years. At present, there is no marked shift out of equities, although that is not to say that funds aren’t thinking about alternative investments.”
Graeme Muir, head of public sector actuarial business, Punter Southall, says: “Most pension funds have an excessive amount of money invested in the UK. What we’re doing with our own clients is to use a more diversified investment strategy, with less in the UK and more overseas. Other asset classes which could also be used include high yield bonds and hedge funds.”
The government seems to agree, and has given LGPS more flexibility in their investment powers.
The Local Government Pension Scheme (Management and Investment of Funds) (Amendment) Regulations 2003 came into effect on 19 November. The main change is that the 25% limit on unit trust and oeic investments by schemes has been raised to 35%. Furthermore, the investment limits for some asset classes are raised – for example, funds can now invest up to 15% in unlisted securities, compared with 10% previously.
However, this is only part of a much wider review of LGPSs which started in 2001. The exercise – being carried out under the auspices of the Office of the Deputy Prime Minister (ODPM), responsible for local government – takes the form of a two-pronged approach.
The Government’s Stocktake exercise is designed to assess the long-term future of the LGPS, while its Strategy exercise is a more short to medium-term review, an attempt to ensure affordability of the scheme in England and Wales, in terms of the local authority’s resources.
Under Strategy Phase 1, draft regulations were issued in September, to take effect on 1 April 2004, subject to Parliamentary approval.
The centrepiece of these regulations is a completely new element – the requirement for each LGPS to draw up a funding strategy statement. The Government Code for the funding strategy statement will be published next April. Each fund will then have to draw up such a statement by the start of the new contribution season (ie, 1 April 2005). Guidelines on how to do this are being prepared by CIPFA, to be published next March.
Other changes, including the replacement of a return of contributions by immediate vesting of pension rights, generally take effect from 1 April 2004. There is also a requirement to provide annual benefit statements by April 2005.
Phase 2 – a consultation paper published in early November – will put into practice recent policy changes in the Pensions White Paper, as well as responses made to the initial Stocktake Discussion Paper. The new rules will take effect from 1 April 2005, after a consultation process to be carried out next year.
This is where the issue of affordability will be addressed. Among the proposals are the phasing out of the ‘85-year’ rule for existing members; increasing the earliest age at which benefits may be paid (other than for ill-health) from 50 to 55; flexible retirement and incentivisation methods to help retain scheme members in employment; and the possibility of allowing new scheme members to pay a higher employee contribution rate from a future date. Statutory consultation takes place early this year.
Any changes in funding strategy will be developed over the following 12 months. The new contribution requirements then start in April 2005.
The Stocktake exercise was started in 2001, and is basically a health check of the LGPS. The last discussion paper was issued in early December. The ODPM will report its findings next year and probably issue a discussion paper on the scheme’s future.
Whatever the changes in legislation, however, the basic equation remains. Deficits can be funded either by higher contributions from current employers and employees, or by enjoying investment returns which are better than expected.
Muir says: “The key thing is how long they are going to take to do this. If for example the fund has a £20m deficit, the authority could pay in £2m for 10 years, or £500,000 for 40. The prudent thing would be to fund the deficits as soon as possible. But the big decision will be the balance between prudence and affordability. More money spent on pensions means less spent on services.”
Muir believes that ultimately the burden of bridging the gap will be placed with the employees.
He says: “It is generally expected that the rules will be slightly changed for new employees joining a fund. They are likely to be asked to pay in a bit more, and take out a bit less in terms of their future pension.”
This of course will prove politically sensitive.
But Muir says: “The employer is now paying over twice what the employee gets because of the emergence of early retirement, and the increase in life expectancy.”
Hull points out that the funding problem is not yet affecting current payments.
He says: “In general, the schemes are not significantly mature, ie, they do not have a high percentage of retired members. So there is still a substantial positive cash flow, and contribution income is meeting current benefit outgoings.”
He suggests that one way to reduce the deficit would be to create more flexibility in terms of when employees retire, either by letting them stagger their retirement, or by delaying it altogether. These would both help the funding problem to the extent that benefits were paid out at a later stage.
But several problems still remain to be addressed.
One big issue is the affordability of the scheme not only to the employers, but to staff, who pay contributions of 6%. One in three local government employees – mainly the lower paid – chooses not to join the scheme.
Hull says: “It is important that schemes continue to support themselves so that membership does not decline.”
He also says that a further issue is the position of employers such as not-for-profit organisations selling services to the council.
He says: “If these employers are allowed in the scheme, they may only be awarded contracts for a limited number of years, so after that time they cease to participate.”
Peter Scales, chief executive, London Pension Fund Authority, is fairly relaxed about the funding issue.
He says: “It is only transient. Over the long-term, we would expect it to smooth itself out. Investment returns should improve, and contributions into the scheme will also increase.”