An inconvenient truth – LGPS Bulletin 36

David Davison

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In my last Bulletin I provided some detail on why the current exit basis used by LGPS funds is based upon excessive prudence and is totally inequitable to exiting charities costing them £100’s of millions in excess exit payments, swelling Fund assets and reducing Council costs.

The approach is unfortunately also counter-productive as it locks charities in schemes by presenting them with unaffordable exit payments thereby increasing risk for other participants in the Scheme. Funds focus on the risk of default and don’t really assess the material risk of future accrual, particularly for organisations with a weak covenant. It could be argued that the greater risk lies with an employer continuing to accrue further liabilities, which they may be unable to afford, which places other employers at risk.

The cessation lottery

Below is a table showing gilt yields and inflation over the last 12 years.

It can be seen from this that yields were broadly above 4% until around 2011 when we began to witness a steady decline to current levels where they are at or below 2%. There has been some volatility in the inflation position though not to the same extent as with gilt yields. Lower gilt yields will be resulting in very materially higher cessation debts being required from exiting employers which often makes them unaffordable.

Cessation debts could have been 2 to 3 times the size depending upon when the cessation debt was calculated. As an example we recently witnessed a debt move by around 50% over a matter of months and because of where the assets were held the employer had no control over the figure during the period when they were awaiting cessation numbers from the Fund Actuary.

Taking cessation payments based on gilt yields may make some theoretical sense where liabilities in Funds are being secured by the purchase of broadly matching gilts. However, very few Funds do this and we would question if that is sensible and a good use of public monies given the longer term view that Funds can adopt, the relatively small proportion of overall liabilities these Funds are likely to represent as well as the potential returns which could be foregone. This would be particularly the case where small exiting employers had very young staff where a 100% gilts-based investment would be wholly inappropriate.

The vast majority of Funds take these cessation payments and continue to fully invest them in their standard growth portfolio meaning the Fund continues to take the investment risk, and indeed return, as demonstrated in my previous article.

Alternative solutions

A number of alternatives exist which could provide for a fairer distribution of risk on exit.

The PWC Report referred to in my previous article suggested the use of Liability Driven Investments which could increase the ‘secure’ discount rate which could be used, thereby reducing exit payments and making exit more affordable.

The cessation basis could also reflect the likely duration of the liabilities with a moving discount rate applied depending upon the likely term the assets will be held. This basis could also be adjusted depending upon the level of any security which could be provided.

We would urge the Ministry of Housing, Communities and Local Government and LGPS to consider these alternative solutions to look to achieve a more equitable distribution of risk and reward.

David Davison

Post by David Davison

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

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