Martin Clarke, the government actuary, has proposed changing the cost-control mechanism used in the reformed public service pension schemes in a bid to tackle the “perverse outcome” of the 2016 valuation.
The mechanism in its current form was put in place as a risk-sharing measure to achieve three key goals: protecting taxpayers from unforeseen costs, maintaining the value of pension schemes to their members, and providing stability and certainty to benefit levels, this last measure achieved by a provision that the mechanism should only be triggered in “extraordinary, unpredictable events”.
If the assessed cost of certain elements of the scheme in question have increased or decreased by more than 2 per cent of pensionable pay compared with their original level, then members’ benefits are reduced or increased accordingly.
Problems with the mechanism emerged when dealing with 2016 valuations, however, when the cost-control element was paused following the judgment in the McCloud case.
We think the recommendation of an additional layer of a qualitative review after a breach is identified is wise. This will allow the mechanism to have increased flexibility to wider economic, social and political issues when reviewing if the benefits offered are affordable and fair to members
Catherine McFadyen, Hymans Robertson
“The preliminary results of the 2016 valuations, which were calculated prior to the pause for the McCloud judgment, the first at which the cost-control mechanism was assessed, showed a breach of the cost-cap floor in all schemes for which results were assessed,” Clarke explained.
“That is, costs were deemed to have decreased by more than 2 per cent of pensionable pay, and therefore member benefits would have been amended to increase commensurately.”
While the reason for the preliminary results being as they were – reductions in assumed future pay increases and life expectancy – they appeared to show the mechanism performing as intended, “when considering this outcome against the objectives of the cost-control mechanism, the context of the recent reforms, and the wider economic environment this could be considered to be a somewhat perverse outcome”, Clarke said.
Additionally, 60 per cent of the cost reduction leading to the breach of the cost floor arose in legacy schemes, “yet the cost-control mechanism can only amend benefits in the reformed schemes”, he continued, arguing that this “disproportionality in the application of benefit change would seem to be tending towards intergenerational unfairness”.
Existing mechanism produced ‘perverse’ outcomes
Another unwelcome outcome produced by the mechanism was that, though employer contribution rates had already risen by 9 per cent before the impact of the mechanism, the preliminary cost-cap results would increase these further, alongside the cost to the taxpayer, Clarke explained.
“Based on this experience, it does not seem possible for the mechanism to be able to protect taxpayers unless it takes into account more of the factors affecting the actual cost of providing a pension,” he said.
Many industry experts concurred with this position. Luke Hothersall, partner at LCP, told Pensions Expert: “At a time when employer costs would have increased anyway, the cost-control mechanism meant that member benefits should also be improved with employers picking up the tab.
“Although in practice, it is unlikely that these cost-control mechanism benefit improvements will actually go ahead because of the interaction with the McCloud judgment, the need for reform of the cost-control mechanism was clear,” he explained.
“It is particularly reassuring to see a proposed validation step in the mechanism, which means that the results of any formula undergo a further ‘sense’ check to ensure the system is working as intended.
“Adding this common sense overlay should hopefully prevent a repeat of the perverse outcome we saw last time round, while also retaining a level of protection for both pension scheme members and the taxpayer,” Hothersall added.
Kirsty Bartlett, partner at Squire Patton Boggs, concurred: “The original intention behind the mechanism – of helping to ensure defined benefit accrual in the public sector would remain sustainable over the long term – is laudable, but it does seem to have been set at a level that will trigger much more frequently than anticipated.
“Regular changes in benefits create unnecessary complexity in scheme administration and make it harder for members to understand their entitlement," she said.
Clarke lauded the principle of the risk-sharing the cost-control mechanism was intended to create, though he noted that difficulties can arise “in the precise choice of components of the mechanism, and the balance of these elements can lead to consequences that might be considered unintended or inequitable”.
Nonetheless, the alternative, a system of review without a “firm mathematical prescription”, would be “open to periodic interpretation, influence and potentially dispute, which would offer less security and certainty”, he argued.
As such, he concluded it would be better to improve the existing mechanism than to scrap it, and laid out a number of ways in which this could be done.
These included removing any allowance for legacy schemes within the mechanism, so it solely considers the reformed schemes. Alternatively, he suggested that the mechanism could be limited to future service accrual in the reformed schemes.
Clarke said the current plus or minus 2 per cent “corridor’ could also be widened to reduce the frequency of breaches, citing 3 per cent as a preferable number.
He also posited the inclusion of an “affordability check”, and an additional layer of qualitative review to be put in place, “which allows for reasoned judgment to be used to determine whether or not to apply the results of the cost-cap valuation”.
Catherine McFadyen, head of Local Government Pension Scheme at Hymans Robertson, told Pensions Expert: “We think the recommendation of an additional layer of a qualitative review after a breach is identified is wise. This will allow the mechanism to have increased flexibility to wider economic, social and political issues when reviewing if the benefits offered are affordable and fair to members.
“The lack of such flexibility was arguably the current mechanism’s biggest failing and weak point. Any new review process will require strong overarching governance arrangements to avoid disputes between interested parties.”
The most fundamental change proposed is the affordability offset assessment. “This would be a change to one of the fundamental ‘rules’ of the mechanism, where members will not suffer or gain from benefit changes as a result of a change in the discount rate,” McFadyen continued.
“This is one of the thorniest issues with cost sharing – the disconnect between the factors that affect the cost payable by employers and the factors that affect the results of cost sharing was the main reason why we saw proposed benefit increases for members (before McCloud) at a time when employer contribution rates were increasing by 5-10 per cent of pay.
“This mechanism would go some way to address this. It also means that public sector employees’ pensions would no longer be fully insulated from the economic factors impacting the costs of providing the pensions.”
Review was comprehensive but not exhaustive
Some experts, though praising the overall depth and rigour of the actuary’s review, nonetheless highlighted areas that perhaps should have been considered but were not.
NAO urges govt to address McCloud’s administrative impact
The National Audit Office has urged HM Treasury to address the administrative impact of the McCloud remedy as a matter of urgency, while highlighting a need to tackle the problem of cost control in public sector pensions.
Alison Murray, partner at Aon, told Pensions Expert that although in hindsight it is “fairly obvious” that the inclusion of past service costs “could be quite material, particularly in the initial post-reform period, we would also question whether some of the assumptions used to set the starting point ‘baseline’ cost were subject to robust enough challenge given their effect on the process”.
She explained: “In particular, the pay increase assumption underlying the baseline cost looks very optimistic in terms of what public servants might have expected, so overstating the initial cost and leading to an apparent reduction in cost at 2016 when the first cost management calculations were carried out.”
The actuary’s review produced no analysis of “whether those baseline assumptions should be revisited, nor whether other [Treasury] assumptions, such as commutation, were reasonable”, Murray added.
