The Local Authority Outsourcing Time Bomb – You Know When You’ve Been Quangoed!

Blog 21 Sep 2005 By
I read with great interest the news that Government ministers had bowed to pressure from local authorities and found an extra £1bn to plug this year’s budget shortfalls, £300m of which was necessary to fund their collective pension scheme deficits. The move followed lobbying by the Local Government Association in an attempt to stave of what would have been a politically unpalatable 10 per cent rise in council tax in the run up to the general election.

The move certainly highlights the benefits of having a ‘daddy with deep pockets’ who can bail you out when times are tough. However, it got me thinking about all those companies who now supply out-sourced services to the local authorities, such as charities, nursing homes and housing associations who are not blessed with a wealthy benefactor (i.e. the taxpayer) who can come to their rescue when additional resources are needed.

Local authorities now outsource many of the functions they previously performed in-house and there has been a significant rise in not for profit organisations specifically set up for that purpose. These bodies which, for example, provide care for the elderly, specialist nursing and childcare support and housing services are funded primarily from local authority budgets with some limited additional support from the charitable sector. This means that their resources are finite. However, they are usually forced to provide salary related pension scheme benefits on a comparable level to the local authorities and often by direct participation in the local authority scheme.

Herein lies the fundamental problem of funding what are essentially private companies on a public sector basis. Pension contributions form an integral part of the local authority budget and, as such, the rates set are subject to the same downward financial pressures as any other area of expenditure. Funding assumptions will therefore be set to control significant increases in contributions, a fact which is highlighted by recent figures which suggest that local authority solvency levels have fallen by 15-20% since 2001 to an average of around 75%. It is however perhaps more acceptable for the public sector to fund their scheme on a more aggressive basis reflecting the strength of the underlying Government covenant.

However, the same contribution rates apply to the private sector out-sourcers who do not benefit from this guarantee and are not necessarily going to continue to provide services indefinitely, indeed, service contracts can frequently be for short fixed periods. The Association of Chief Executives of Voluntary Organisations (ACEVO), whose members are major suppliers to local authorities, have gone so far as to describe the current situation as being of an “insecure, short-term, risky nature” and commented that “risk and uncertainty is badly managed.”

It would therefore be reasonable to expect that these organisations would have to fund their pension schemes on a more cautious basis. This is particularly important when you consider that most, if not all, of these bodies have very limited access to increased income and have limited capital resources, meaning that any undervaluation of a liability becomes difficult, if not impossible, to fund from reserves or future income.

So what does all this mean? These bodies will have built up deficits over the past few years and our experience with those who have to produce FRS17 figures is that these deficits are significant. Worryingly, bodies which are exempt from the provisions of FRS17 will in all likelihood be totally unaware of the extent of the problem with which they are now faced.

The deficits for service accrued to date must be met via increased future contributions – contributions which have to be funded for from future income, thereby requiring additional costs to be transferred to the local authorities.

The question here must be, will the local authorities be prepared to pick up the full cost of this or only a proportion of it, given that part of it relates to service for a previous contractual period where there is no clear ongoing benefit to the authority. If they decide not to pay for the outsourcer’s failure to adequately fund benefits in the past, then the outsourcer will have to find resources from reserves, which are frequently limited or non-existent, or from other income such as charitable donations, likely to be a highly unpopular move.

With significant improvements in life expectancy and lower expected future returns on investment, it is very likely that the cost of accruing future benefits will also rise, thereby further increasing the contribution required and this will also need to be factored in to the service budget.

Whilst many outsourcers and local authorities alike may not have a recognition of this specific issue, many local authority pension schemes in recent years have become all too aware of the investment risks to which they are exposed. In the 2004 Charity Finance Directors Group (CFDG) Report “The Charity Pensions Maze” the authors suggested that “Pension investment performance is now a live and real risk issue for charity trustees and directors.”

The report goes on to say “trustees and directors urgently need to think about the implications and legal liability issues….., and to work out how to manage the risks that result.” So even if the figures themselves do not need to be formally disclosed under FRS17 in the accounts it can only be good corporate governance to review the level of legal and risk issues associated with pension provision and identify ways of controlling that risk.

There has been a significant rise in the use of hedge funds and swaps in public sector schemes in an attempt to achieve real returns whilst controlling the investment volatility to which they are exposed and it will be interesting to see the impact of these decisions over the coming years.

A considerable amount of faith is being placed in equity returns to save the day but it is unlikely that this will be a quick fix. Recent experience has shown that despite reasonable levels of equity return over the past couple of years scheme solvency levels have not materially improved given the reduced bond yields experienced over the same period. Research suggests that UK deficits are now more stable but have still not begun to improve so an inexorable rise in contributions seems likely.

Ultimately there is no guarantee that the situation could not continue to worsen in the future, being particularly exacerbated by the aggressive funding stance adopted by the local authorities, which in itself begs the question as to whether taxpayers and ratepayers are aware of the potential downside in underwriting this guarantee.

The bottom line here is that final salary pension scheme liabilities represent an unknown funding cost and a little recognised consequence of the local authority outsourcing boom is that the local authorities have managed to transfer their unknown pension liabilities costs to a third party supplier for a fixed cost and it is the supplier who is responsible for the liability – a very neat three card trick!

The first major step required would be a recognition of the problem and its magnitude among Government, local authorities, trustees of the bodies, pension scheme trustees and advisors and for positive solutions to be sought and actions taken. Local authority suppliers need to seriously look at the funding assumptions that are being made on their behalf and identify the level of risk to which they are exposed, as well as considering potential options to minimise the future risks involved.


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Published in Pensions Management Magazine September 2005

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