Govt to reform discount rate and cost-control mechanism

The first of the two consultations published on Thursday by HM Treasury concerns the timing of reviews of the Superannuation Contributions Adjusted for Past Experience discount rate, used to determine contribution levels paid into unfunded public sector defined benefit schemes.

Its purpose is to ensure these contribution rates are set so that the value of benefits earned today, as well as past over or underpayments, is recognised and properly reflected in total contributions.

It is also meant to ensure that employers pay an appropriate charge for public service pension schemes, and that decisions made by the government and public service employers about their workforce, such as how many people to employ and on what salary, take into account the full future cost of employing people today.

The taxable economy growing at 1 or 2 per cent per annum, but pension costs growing at 2.4 to 3.5 per cent per annum implies very difficult political decisions ahead. Guaranteed future austerity?

Allan Martin, ACMCA

The government last consulted on the Scape rate methodology in 2010, at which point it was decided that reviews should be carried out every 10 years, while reviews of the rate itself should be carried out every five years.

The government will carry out a second exercise to set the discount rate following the conclusion of the consultation into the methodology used to set it, which proposes to align future rate reviews with scheme valuation dates.

Scheme valuations ‘particularly sensitive’ to Scape discount rate

The consultation document explained that scheme valuations are “particularly sensitive to the Scape discount rate”. 

“For example, 2016 scheme valuation reports found that a 0.25 per cent change in the Scape discount rate could change employer contribution rates by between 4 per cent to 11 per cent of pensionable pay,” it stated. 

It further explained that contribution rates affected by changes in the Scape discount rate indirectly impact the cost of unfunded public sector DB schemes, for instance by affecting the cost of employing staff, or where the Scape rate is itself used by a scheme to calculate the cost of benefits.

LCP partner Mike Richardson told Pensions Expert that the proposal to align the Scape review periods with the valuation cycles of the public service schemes, while retaining flexibility as to when in the cycle the review is carried out, “makes a lot of sense – and would help reduce the risk of unexpected increases in costs, such as those caused by the April 2019 Scape change”.

“It would also make sense for the Scape review to consider the expectations for [gross domestic product] growth over different time frames – given there can be such large differences between forecasts over different periods,” he said.

“That said, it is important to strike the right balance between simplicity and accuracy; allowing for changes at too granular a level runs the risk of spurious accuracy and additional complexity for no real benefit.”  

Stability was another focus of the consultation, with Robert Bilton, head of Local Government Pension Scheme valuations at Hymans Robertson, observing that the government’s desire for stability “is not surprising after the significant increases in employer contribution rates to these schemes after the last round of valuations at 2016”.

“The government’s desire for stability will aid budgeting for employers whose staff participate in these schemes and, as was the case in 2019-20, avoid HM Treasury having to provide last-minute additional funding to cover any future increases,” he said.

However, he questioned “whether the best approach to achieving stability is through the discount rate”, given that for it to represent “a realistic estimate of the future”, it must be expected that it “will fluctuate over time as the wider economic and social environment changes”.

“It should not be artificially adjusted to provide a stable result. Instead, it would be preferable for the valuation to provide a true, realistic cost of pension provision for the schemes,” Bilton said.

“Thereafter, through modern risk-based valuation methods, a stability overlay can be applied to help smooth out contribution rates while ensuring intergenerational fairness.”

David Robbins, senior consultant at Willis Towers Watson, argued that it might make sense to align the Scape rate review with the spending review period, “so it is clearer how much of the budget allocated to, say, the NHS – and in turn to particular hospital trusts – is likely to be needed for pension costs”.

Rising pension costs will force ‘very difficult political decisions’

Allan Martin, director at ACMCA, pointed to the long-term underperformance of GDP growth and its interaction with the discount rate as a reason to fear “very difficult political decisions” in the long term, possibly including “guaranteed future austerity”.

“The Scape discount rate is of huge public interest. Six million very important public sector workers deserve a DB pension, but contributions and benefits need to be fair and sustainable,” he said.

While unfunded public sector liabilities now exceed £2.1tn, GDP growth “has not been as expected” since 1989, and “a 1 per cent shortfall for one year equates to £21bn, roughly equal to 2p on income tax or 3 per cent on value added tax”, Martin continued.

“The taxable economy growing at 1 or 2 per cent per annum, but pension costs growing at 2.4 to 3.5 per cent per annum implies very difficult political decisions ahead. Guaranteed future austerity?” 

Cost control reform goes ahead

Also on Thursday, the government published proposals to reform the cost-control mechanism used in public sector pension schemes.

As previously reported by Pensions Expert, Martin Clarke, the government actuary, put forth a number of possible reforms in his review of the mechanism after it was found to produce “perverse” outcomes.

The preliminary results from the 2016 valuations showed a number of unintended outcomes, increasing the cost to employers and the taxpayer, and acted in a way that suggested it was too volatile.

The government has chosen to move forward with three of the proposals made by the government actuary.

First, it will move to a “reformed scheme-only design”, which will “remove any allowance for legacy schemes in the cost-control mechanism, so the mechanism only considers past and future service in the reformed schemes”, the document stated.

The government also concurred with the actuary about widening the corridor from 2 per cent to 3 per cent of pensionable pay.

Finally, while the mechanism at present does not include changes in long-term economic assumptions, “and therefore cannot consider the actual cost to the government of providing pension benefits”, the reformed mechanism will feature a check “so that a breach of the mechanism would only be implemented if it would still have occurred had the long-term economic assumptions been considered”.

LCP partner Nikki Ayriss told Pensions Expert that the “proposed so-called ‘economic check’ introduces a validation step so that those unintuitive outcomes from 2016 wouldn’t happen”.

“This check would work both ways, so would also prevent a cut back in members’ benefits at the same time that employer contributions were falling,” she explained.

“The width of the corridor within the mechanism is a real balancing act – widening the corridor should reduce volatility in terms of the frequency of benefit changes, but does mean that the costs can get further out of line before there is any correction by way of adjustments to benefits.

“On balance, increasing the corridor from 2 per cent to 3 per cent seems a reasonable approach.”