Govt presses ahead on public sector schemes cost-control reform

As reported by Pensions Expert in June, HM Treasury took forward three reforms to consultation that were first suggested by the government actuary after a review of the mechanism found it had produced costly, unintended outcomes.

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”.

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.

A wider corridor of plus/minus 3 per cent may prevent confusion and disruption for schemes and members by reducing the likelihood that smaller, temporary fluctuations in costs within the corridor will lead to benefit changes, which may then be reversed at subsequent valuations

HM Treasury

In a consultation response published on Monday, the Treasury took forward three reform proposals to consultation. The first was moving to a “reformed scheme-only design”, so that the mechanism only considers past and future service in the reformed schemes, and costs related to legacy schemes are excluded.

The second was widening the corridor from plus/minus 2 per cent of pensionable pay to plus/minus 3 per cent, with the aim being to ensure consistency between the benefits being assessed and the set potentially being adjusted, thereby creating more consistency in the system.

The third was the introduction of an “economic check” in order that the cost-control mechanism is able to reflect the actual cost to the government of providing pension benefits. Under this system, a breach of the mechanism “would only be implemented if it would still have occurred had any changes in the long-term economic assumptions have been considered”, the government’s consultation explained.

Reformed scheme-only design

The government received 61 responses to its consultation into the reforms. In its response, it claimed the industry had expressed broad support for the first two reforms, but a mixed reception greeted the proposals for an economic check, with which it is nonetheless pressing ahead.

A “high majority” of respondents agreed with the proposed move to a “reformed scheme-only” design. 

“In its consultation, the government proposed excluding costs related to the legacy schemes so that, going forward, the mechanism would only consider costs associated with members in the reformed schemes (both past and future service),” the government’s response stated. 

“A reformed scheme-only design would ensure consistency between the set of benefits being assessed and the set of benefits potentially being adjusted.”

It also argued that the proposal would reduce intergenerational unfairness, as “comparatively younger members” would “no longer experience changes to their benefits based on the cost of providing benefits to comparatively older members with past service in a legacy scheme”, a point on which it found widespread agreement.

A “small minority” argued that a reformed scheme-only model would merely have a “short-term impact”, arguing that a “future service-only” model would be preferable. This was the view of the Association of Consulting Actuaries, as reported by Pensions Expert.

In its response, the government agreed with some of the arguments for such a model, but argued that it would not be right for the exchequer — and so, the taxpayer — to bear “the entire risk of costs associated with past service in the reformed schemes”.

Widening the corridor

Widening the corridor from the existing plus/minus 2 per cent of pensionable pay to plus/minus 3 per cent was touted in the consultation as being key to bringing more stability to the system, in part by reducing the frequency of breaches.

The government noted in its response that a “majority” of respondents favoured widening the corridor, and a “slight majority” favoured plus/minus 3 per cent.

Some respondents said widening the corridor by such an extent would make changes too infrequent, attaining stability in the mechanism at the cost of control.

The government also noted that a majority of respondents, including those who agreed with the proposal, raised concerns “that widening the corridor exacerbates the ‘cliff edge’ nature of the mechanism”. 

Some also felt that even a plus/minus 3 per cent corridor would not produce stability for certain schemes, arguing instead for a proportional cost corridor that would vary with the size and costs of individual schemes.

In its response, the government accepted that a wider corridor would increase “the cliff edge nature of the mechanism”, but explained that a wider corridor “will not mean that different action would need to be taken if a breach beyond plus/minus 3 per cent was observed. For example, a breach of plus/minus 4 per cent would still require the same changes in benefits under either a plus/minus 2 per cent or plus/minus 3 per cent corridor”.

It argued that it is “not correct to assume that if a scheme shows cost changes between 2-3 per cent at one valuation, then that automatically means that costs would either stay at that level or move further in the same direction at subsequent valuations, and therefore result in a breach that would be larger than under a smaller corridor”. 

“A wider corridor of plus/minus 3 per cent may prevent confusion and disruption for schemes and members by reducing the likelihood that smaller, temporary fluctuations in costs within the corridor will lead to benefit changes, which may then be reversed at subsequent valuations,” the response stated.

Economic check

The proposed introduction of an economic check drew a mixed response, with the government noting that it received about as many responses in favour as responses against the change.

Though previously hailed as a way of bringing stability to the system, some respondents argued it would be a breach of the 25-year guarantee, a “significant departure from the process for the cost-control mechanism originally agreed between trade unions and the government and that, during discussions at the time, it was strongly suggested by the government that the originally agreed cost-control processes were covered by the guarantee”. 

“A related concern was that the government has previously made explicit promises that employers would meet any costs arising from changes to the [Superannuation Contributions Adjusted for Past Experience] discount rate, and that such impacts would be excluded from the cost-control mechanism as they were not member costs,” the government noted.

Some respondents said they feared that an economic check could be subject to political interference, while respondents from the Local Government Pension Scheme argued that an economic check tied to long-term gross domestic product would not be appropriate for the LGPS.

The government said it had “considered all responses and maintains the view that an economic check should be introduced for all schemes, with further consideration required for potential allowances for the LGPS”.

It argued that a cost-control mechanism could not be effective without some consideration for the long-term economic outlook, but accepted that any such economic check would have to be transparent and objective.

In response to the LGPS, the government said it had taken into consideration the concerns raised by LGPS stakeholders that an economic check linked to expected long-term GDP growth is not appropriate for the funded LGPS”. 

“The government recognises the different nature of the LGPS,” it continued, but said that “on balance” it “still believes that the economic check as a whole is an appropriate proposal for the LGPS”.

The Treasury is aiming to implement all three proposals in time for the 2020 public sector scheme valuations.

“It is necessary to implement the reformed scheme-only design and the economic check through expanded powers in primary legislation, when parliamentary time allows, and then by making Treasury directions under those powers in due course. The wider cost corridor will be implemented to a longer timeline via secondary legislation,” it said.