Posts Tagged ‘cessation debt’

David Davison

The Security Obsession

In an earlier bulletin entitled ‘The Cessation Plot thickens’ I highlighted something of an anomaly in LGPS practice around security which I’d like to explore a bit further.

Firstly, I will consider an example of an admitted body looking to close off to accrual to better manage risk. Prior to doing this let’s assume that the organisation has £1m of accrued liabilities and £800,000 of assets covering them so a deficit of £200,000. The organisation is building further liabilities of £50,000 a year. Contributions for these new liabilities are £20,000 a year so each year the net position is worsening by £30,000 (excluding any investment return).

As an active employer the Fund has not taken any security so the Fund and therefore other participating employers are exposed to additional risk as liabilities continue to build.

If the admitted body was permitted to close to future accrual of benefits the accrued benefits are no worse pre and post the change (they will likely be lower afterwards if the link to salary on past benefits is removed), so why should security be required when none was previously in place. In addition a proportion of the contributions which were being used to build additional benefits in the Fund could be used to pay down the existing benefits rather than build up new ones. Let’s assume some of the £20,000 is needed to buy replacement benefits in another scheme so only £15,000 is available as a contribution. This will therefore reduce the deficit over time thereby reducing the risk to the Fund. This can only be good for all concerned and further supportive of the view that no security is needed.

So, why is there an obsession for Funds to get access to security on scheme change? It’s probably because they’re using it as an excuse to do so! A bit of a reality check is needed.

It’s potentially reasonable for Funds to look for security if some additional flexibility is being offered, such as access to a higher risk investment fund where the deficit risk could increase but without this the default position should be that additional security should not be necessary.

So if you’re being pushed for security by a Fund you may need to ask a few more questions, especially as any arrangement of this type is likely to be time consuming and expensive to arrange.

In my view there should be clear and consistent guidelines which Funds employ in relation to the provision of security. Some Funds are adopting a more pragmatic and indeed enlightened approach to the issue of security and it can only be hoped that others will begin to follow suit, especially if admitted bodies ask the right questions.

David Davison

The question I’m asked about most often is about the cost of exiting a LGPS, as for most charities the costs can come as a bit of a surprise. One organisation I worked with recently had a small surplus at their last actuarial review and in their accounts, but when a couple of their staff left unexpectedly they were immediately hit with a bill from the fund in excess of £500,000, pretty much wiping out all their assets and placing them on the brink of insolvency. So what do you need to know?

Should you run out of active members in your LGPS fund (and not be in a position to add any new ones, for example if you have a closed agreement or a local authority contract has come to an end) under the LGPS Regulations the fund must commission the Fund Actuary to complete a cessation valuation. Whilst the Regulations do not prescribe how this calculation should be carried out, the actuaries undertaking the calculation will use very prudent ‘least risk’ assumptions based on gilt yields. This will result in liabilities being much higher than is the case on either a funding or accounting measure. Often this is the first point that an admitted body may be aware of this liability, as unfortunately numerous funds still do not provide organisations with an annual estimate of the potential cessation debt.

The conservative approach taken reflects that once an organisation exits an LGPS, the fund cannot pursue them for any extra money if the cost of providing members’ benefits is higher than expected. The fund therefore wants to make sure that there is a minimal risk that other employers in the fund would be responsible for paying for any of these exiting liabilities. As such the approach is a protection for all. However, what has been called in to question more recently is whether the basis adopted is reasonable, and indeed suitable in all circumstances. What is clear however, is that there is a great reluctance on the part of the funds to change, not surprisingly.

Whilst the approach to calculating a cessation debt across Funds, and across the various fund actuaries, tends to be consistent, the circumstances in which it applies can vary significantly. For example, some funds offer public sector out-sourcers ‘pass through’ protection, which means that any cessation debt is calculated on the much lower on-going funding basis. Other funds recognise where the last employer has inherited significant liabilities from a public sector body, and will account for these by ensuring that the public sector body picks up their fair share. Unfortunately, though the vast majority of funds do not.

Some funds are prepared to negotiate around the cessation amount payable, subject to affordability and the term of any repayment. However, in most circumstances these negotiations need to be conducted in advance of any formal debt trigger / calculation.

Admitted bodies therefore need to be aware of their situation and look to plan for it, as far in advance as possible, as allowing a cessation event to just happen could have catastrophic implications for the charity.

In my next bulletin I’ll consider why change should be considered.

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