Charges out of control in ‘death spiral’ LGPS

Huge discrepancies persist between the costs paid by local authorities within the Local Government Pension Scheme, with Cheshire paying total costs per member nearly 19 times those of West Yorkshire, according to a new report.

In a report, The LGPS: Unsustainable, published by the Centre for Policy Studies last week Michael Johnson reveals that notwithstanding Lord Hutton’s 2014 reforms, the scheme’s financial deterioration continues, despite an £833m increase in employer contributions last year. It shows Cheshire paying an overall cost per member of £530, compared to West Yorkshire’s £28.

The report says LGPS costs increased 40 per cent in the year to April 2015 to £878m, of which £748m was third party fund management costs and £130m in administration costs.
Johnson argues the scheme ultimately risks running out of cash to meet pensions in payment, because of excessive pension promises relative to contributions. He argues this has been facilitated by years of abysmally ineffective governance that has been made even more complex by the introduction of Pension Boards. Further pressure will be put on the scheme with the withdrawal of £700m of contracted out rebates from April 2016, and Lord Hutton’s 63 per cent increase in accrual rate from 1/80^th to 1/49^th in 2014 and 10-year grandfathering that has rendered his cost saving proposals impotent for a decade.

The report says some local authorities have responded positively to a Chartered Institute of Public Finance and Accountancy request to improve transparency of cost reporting, but others have not. Increasingly transparent reporting practices will reveal increasing level of costs he predicts.

The report says the average funding level across the LGPS was 79 per cent, equating to a 21 per cent deficit, equivalent to £47 billion in cash terms. He predicts this figure to increase significantly at the time of the next triennial valuation at the end of March 2016.
Johnson says the LGPS would be the sixth largest in the world if it were a single fund, while the Greater Manchester/Tameside scheme, the largest individual fund, ranks just 172^nd, leaving schemes with little scale and purchasing power.
He argues that the weakest funds are already in a death spiral, selling assets simply to meet pensions in payment, with no realistic prospect of recovery. He says the 4 per cent annualised return envisaged 10 years ago at the time of Lord Turner’s Pension Commission is no longer suitable, with assumptions of nearer 2 per cent more appropriate.
Johnson says: “The LGPS is huge: it matters. At end-March 2015, it had assets of £214 billion and 5.17 million members, more than 10 per cent of all adults in the UK. During the last year, had employer contributions not risen substantially – by £833 million – cashflow would have continued its long-term deterioration.  This unambiguously signals that the LGPS is unsustainable. Given that employer contributions are predominately taxpayer-funded, a surreptitious state-funded bailout has commenced. But over the next decade the scheme faces a perfect storm, due to a combination of past under-funding, the end of contracting out rebates, potentially sclerotic investment returns in a post-QE world, employers opting out of the scheme, an ageing membership, a crippling accrual rate and ten year grandfathering from 2014, which effectively renders Lord Hutton’s (cost-saving) proposals impotent for a decade.
“And while 2013’s £47 billion deficit is expected to increase at the next triennial valuation in March 2016, it is negative cashflow that is likely to be the LGPS’s undoing.”
City Noble director William Bourne says: “Michael Johnson is not wrong to point out some looming issues facing the LGPS Scheme:  demographics are going in the wrong direction; the cost to employers is becoming unsustainable, though there is of course a cost cap to protect them; asset returns over the next five years are likely to be lower than the ‘easy’ years of QE.

“I have less sympathy for his arguments on cost disparities between authorities. I agree that some public sector schemes could be run more efficiently, and that standardised data on costs would help less efficient funds to benchmark their performance more effectively.    Against that, there are plenty of well run, efficient schemes, as Johnson attests, which compare favourably with the private sector.  Many factors go into cost disparities, including size, investment strategy, and allocation of shared costs.  The data, particularly year on year changes, should not be used to castigate without a deeper dive.

“While I agree with Johnson that, as currently constituted, the LGPS Scheme is unsustainable, I disagree in the diagnosis.  The nub of the problem is on the liability side and caused by the Government’s weak negotiating in previous years.  As Johnson alludes, the settlements in 2008, 2010, and 2014 were too generous to the employee.    In particular, the change from 1/80 to 1/49th accrual rates, which is where his 63 per cent ‘increase’ comes from, was Government imposed.  The ten year ‘grandfathering’ again was the Government’s decision. He makes a good point about the misalignment of pensions in payment, but again the decision to index to CPI and not RPI in 2010 was a Government decision.   And of course, back in 1997, the decision to remove the tax credit from dividends, which is at the root of the demise of private sector DB schemes, was again the Government‘s doing.

“Johnson calls the deteriorating cash flow in unfunded public sector schemes the ‘cashflow canary’ which points the future for the LGPS scheme.  The better run LGPS funds, which is admittedly not all, have been well aware of this for the past five years, and have put in place asset programmes which generate sufficient income to pay the cashflow deficit from income generated by their assets.

“And I would remind Johnson that if the LGPS Scheme liabilities were put on the same actuarial basis as the Government actuary chooses to put unfunded public sector schemes, i.e. CPI +3 per cent, the LGPS deficit would be almost eliminated. Johnson’s concluding paragraph states that ‘reconfiguring the LGPS as a few British Wealth Funds with an infrastructure bias will not address the fundamental issue that it is unsustainable. It will not ameliorate the pending cashflow crisis, nor repair the deficits.’   I just hope the solutions he promises focus on the real problem, the liabilities, and that he keeps in mind the need to ensure that any change’s primary objective should be a better outcome for the 4.85m pensioners in the LGPS scheme.”