Actuaries propose changes to public sector pension increases

In its response to the consultations on reforms to the cost-control mechanism and the Superannuation Contributions Adjusted for Past Experience discount rate used for public sector schemes, which closed on Friday, the ACA also warned of the need to ensure a balance between cost and stability in the cost-control mechanism, an opinion also shared by the Local Government Pension Scheme Advisory Board.

As reported by Pensions Expert, Martin Clarke, the government actuary, put forth a number of possible reforms in his review of the mechanism, after 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 chose to move forward with three of Clarke’s proposals. It consulted on changing 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 consultation stated.

There are clear advantages to employers and the taxpayer if structural changes are factored into benefits more promptly by retaining the current 2 per cent corridor, but it could be an administrative and member communication nightmare if in the worst-case scenario benefits change every four years

Luke Hothersall, LCP

The government also concurred with the actuary about widening the corridor from 2 per cent to 3 per cent of pensionable pay, in the hope that this would create more stability, and on the addition of an “economic check” to the mechanism “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”.

Robert Bilton, head of LGPS valuations at Hymans Robertson, said: “We welcome the proposed changes to the mechanism, and the stability these will bring to future cost-cap valuation results.

“In particular, the ‘economic check’ will help to reduce the potential for ‘perverse’ results to occur. The check should make it less likely that we will see a recurrence of the situation where benefit improvements are proposed at the same time as contribution rate increases from the 2016 actuarial valuations.”

The response was not uniformly positive, however.

The ACA agreed with removing legacy schemes, but cautioned that with the proposed “reformed scheme-only” design, over time the reformed schemes’ past service “will increase and bring more risk into consideration for sharing with members”. 

It said: “Having a process that adjusts future service rights to recover notional past service surpluses/deficits is likely to cause intergenerational fairness issues. The rights of new joiners will be increasingly influenced by the past gains/losses of older joiners, and this will lead to stability issues for the mechanism in the longer term.”

The association argued that a “future service-only” model would be the best and fairest way forward.

Wider corridor questioned

The ACA agreed with the need for stability, since under the present system, even if a reformed scheme-only model is picked, modelling from the Government Actuary’s Department shows that changes will be required every 20 years, meaning the average worker might see two or three changes during their working life.

While welcoming steps to reduce the number of changes, it cautioned that the proposed widening of the corridor in the cost-control mechanism to plus/minus 3 per cent was not without issues, as the resulting change when the mechanism is breached would be larger than it is at present.

“There should be a balance between stability of the frequency of change of benefits and the stability of the level of benefits,” it said.

The LGPS Scheme Advisory Board also warned against the change, arguing that widening the corridor in order to achieve stability would not be “a prudent way to identify and manage structural changes to the cost of the scheme”.

The SAB currently operates a separate cost management process to the cost-control mechanism, but that process is subordinate to the Treasury’s. It is currently designed on a plus/minus 2 per cent basis.

Luke Hothersall, partner at LCP, told Pensions Expert: “Setting the width of the corridor is a balancing act between theoretically more stable employer costs (if the corridor is narrow) and more stable benefits for members (if the corridor is wide, albeit with significant ‘cliff edges’).

“There are clear advantages to employers and the taxpayer if structural changes are factored into benefits more promptly by retaining the current 2 per cent corridor, but it could be an administrative and member communication nightmare if in the worst-case scenario benefits change every four years.”

He added that it is “important to consider all of the components together, as well as individually”.

Widening the corridor “looks like a plausible (albeit not ideal) way to try and avoid further perverse” outcomes” if there are no other changes to the mechanism, he said.

“If legacy benefits are excluded from the mechanism in the future and a validation step is introduced, the arguments for any widening of the corridor are greatly reduced.”

Scape and ‘economic checks’

The government was also consulting on the timing of reviews of the Scape rate, used to determine contribution levels into unfunded public sector schemes.

Five objectives currently apply when considering the Scape rate, which is meant to provide a fair reflection of costs, reflect future risks to government income, support the plurality of the provision of public services, be transparent and simple to understand, and create stability.

The first two of these are prioritised, and the government’s consultation proposed adding stability to the list of “core objectives”.

The government also asked for industry views on a Scape discount rate methodology based on long-term GDP growth and the Social Time Preference Rate, which the consultation described as “an estimation of society’s preference for consumption sooner rather than later” that is used by the government “to appraise the value for money of projects which involve short-term public expenditure to deliver future welfare benefits”.

In response, the ACA said: “Whatever method is used [...] the resulting assumptions will almost inevitably either overestimate or underestimate the true cost of paying these pensions for future generations of taxpayers.

“The underlying reason is that the pensions are linked with inflation and not to future economic growth, which is the driving force of our economy’s ability to pay these pensions.”

Bart Huby, chair of the ACA Pensions in Public Services Committee, said: “A fairer way of dealing with this issue would be to change the way unfunded public service pensions are increased from inflation to economic growth.

“This would meet the key objectives of the exercise, in particular intergenerational fairness and risk control. If the economy grows faster than anticipated, the pensions for public servants would increase faster than inflation. Conversely, if the economy grows slower than expected, then pension increases would be lower than inflation.”

Both Hymans Robertson and the SAB argued that the Scape discount rate should not be used as an economic check for the purposes of the cost-control mechanism, however.

Hymans suggested that the cost-control mechanism uses a discount rate, “which reflects the expected return from the overall asset allocation of LGPS funds”, while the SAB has recommended the government ask the GAD to look at a “neutral” LGPS discount rate based, for example, on the OBR’s long-term forecasts for global GDP growth.

Hothersall said: “It’s hard to see how any of the options proposed for the Scape rate could be considered appropriate for LGPS funds in any context, so using some kind of LGPS-specific rate appears to make sense.”