The great Eagles song Hotel California has the immortal lines “You can check in any time you like, but you can never leave” which perfectly sums up a growing crisis brewing between the public and private sector.
There has been a huge increase in numbers, as well as a burgeoning in size, of not for profit organisations over the past few years fuelled by the local authorities almost insatiable appetite for out-sourcing of public sector services. There are few service areas which have remained untouched with major charities, and other specialist bodies providing services in housing, care of the elderly, healthcare, childcare to name but a few. The majority of these bodies are small, run on tight budgets and many receive in excess of 90% of their funding from the public purse. Significant growth in this sector continues as the government seeks to control its public spending by laying off liabilities to these private sector suppliers.
There-in lies a major problem as in order to compete for contracts, not to mention be competitively placed to compete for staff, many of these organisations must offer final salary pension benefits. In common with many other private sector organisations, they have therefore been hit by a significant increase in pension liabilities as more realistic valuation assumptions have become the norm.
Whilst the private sector continues its inexorable move away from final salary pension provision there is no similar impetus in the public sector given the Governments underwriting of the ultimate benefits, although even they have been considering alternatives lately.
Options are more limited for the out-sourcing sector. Many of these organisations participate in multi-employer schemes or directly in the local authority pension funds. The contracts they are offered to provide services are generally on a fixed term basis and there was much Government lobbying at the end of 2004 to attempt to lengthen the terms of these contracts to give the bodies some additional financial security. The Association of Chief Executives of Voluntary Organisations (Acevo) have gone so far as to describe the current situation as being of an “insecure, short-term, risky nature.”
Invariably the bodies join a local authority pension scheme and are provided with a contribution rate to fund for their staffs’ pension benefits. Using this contribution rate they set their budgets to tender for work for the period on offer. Given the pressure on Local Authority funding these budgets will generally be competitive with only small contingency margins.
If we now move a few years down the line to the point where the contract period ends and the financial position becomes somewhat clearer. Contributions to buy final salary benefits are unknown and are arrived at using a set of financial and demographic assumptions. Should these assumptions be overly optimistic then insufficient contributions will have been paid to meet the liabilities accrued and a scheme deficit will have built up. Such is the position many not for profit organisations find themselves in today.
Gillian Donald, Charity Partner at Chartered Accountants Scott Moncrieff commented that “many of these bodies will have built up significant deficits for which they will need to contribute additional monies. In addition the cost of continuing to accrue benefits in the future will also rise so they’ll be hit with a ‘double whammy.'”
Where do these contribution rates come from? From Local Government, who can afford to take an aggressive view on its funding assumptions because, if they turn out to have been overly optimistic, it can rely on the public purse to fill the hole. Funding on this basis may be acceptable where a strong employer covenant exists (such as from the Government) and where tenure of employment is secure however neither of these is this case in this sector. No underlying guarantee exists and short term contracts make funding on an aggressive basis untenable.
Few of these not for profit organisations have much, if anything, in the way of reserves. Realistically the only way to fund the contribution is to raise future costs, however will their primary customer, the local authority, be prepared to accept these costs or will the tender go elsewhere? And if it goes elsewhere what happens to the existing provider? Will the local authority be prepared to pay for a historical deficit which has arisen during the period of a fixed price contract?
It is the familiar scenario of rising pension scheme costs and significant deficits which exists in the private sector, however, in the private sector there is rarely any compulsion to provide benefits on a final salary basis going forward and past benefit deficits can be met from additional calls on shareholder funds. Neither of these options exist in the out-sourced sector. The bodies do not have additional resources upon which to call and it is next to impossible to leave the local authority pension scheme as exit will result in a more stringent valuation basis being applied with a commensurate increase in costs. Even if funding was available, there is often little flexibility available within the scheme to pay increased contributions to either offset the deficit or minimise the chance of it increasing as a result of future accrual of benefits.
The public sector has very deftly transferred their unknown liabilities on to the private sector at a fixed cost, a cost they have recently been forced to subsidise from the public purse for its own staff pensions to the tune of £300m.
This sectors work is vital. Malcolm Wicks MP, the former pensions’ minister said that they “make an enormous difference to the quality of life of us all.” However if this sector is not only to survive but to continue to flourish it will require concerted effort on a number of fronts.
The first major step would be recognition of the problem and its magnitude among local authorities, trustees of the bodies, pension scheme trustees and advisors and for positive solutions to be sought and actions taken. The bodies in particular need to be looking at the position in which they find themselves and looking at the options open to them to minimise further risk exposure.
Published in The Herald on 04/04/05