News & Views

Give the London boroughs and the LGPS a bit of a break

The Pensions Institute’s recent discussion paper, “An evaluation of investment governance in London Local Government Pension Schemes”, highlights a number of valid concerns about the standards of investment governance amongst the London Boroughs.  However, their critisism of the prudence of the actuarial assumptions appears misplaced, given the history of the scheme, the possible alternatives and the scale of the unfunded government schemes.

Changes in direction by central government have clearly influenced the current funding position and, consequently, the level of prudence in assumptions.  The damage caused by the Thatcher government’s raid on local authority pension funds may never be repaired.  By advising schemes to target a funding level of 75% in order to deliver council tax cuts or freezes, the Thatcher government created the culture, in the Audit Commission’s words, ‘where unfunded liabilities are deferred into the future to make the scheme more affordable to employers in the short term’.  When central government then turns around and asks schemes to again target full funding, it has to be expected that this will new goal will not be achieved overnight, even in times of economic plenty.

In the current era of economic austerity where local authorities cutting their spending, where are they expected to find the extra funding for the pension scheme?  In the past they had much greater discretion over their budget to find the funds.  The last Labour government, eager to pursue their education priorities, removed local authorities discretion over funding for schools and colleges and ring fenced the education grant to ensure that it could only be spent on education, effectively, significantly reducing the discretionary spending available to local authorities.  The scope to find the necessary funding for the pension scheme in the short term now falls on a much smaller group of services.  For example, would tax payers consider it acceptable to cut care for the elderly now in order to fund pensions 20 years in the future?  As the report suggests, this is not a vote winner for local councillors.

Achieving the current round of austerity is placing new pressures on the LGPS.  Many local authorities are choosing to outsource services as a means of achieving cuts, in the process transferring employees to the new outsource provider.  These employees often become members of the new outsource providers pension arrangement and become a deferred member of the LGPS.  This decreases the number of active members in the LGPS scheme to fund the existing increasing the level of contributions for each active member.  It is not surprising that the report finds that private sector schemes can eliminate the deficit over an average of 9 years, with an average employer contribution of 14%, while the London schemes will take on average 20 years with an average employer contribution of 22%.  I expect that this differential will increase in parallel with the increase in outsourcing by local authorities.

Faced with the pension issues of the LGPS funds most private sector schemes would close the scheme to new members and possibly also future accruals, thereby capping the liabilities.  In the LGPS scheme, liability management is the preserve of central government and the current political climate does not make closing the scheme a possibility.

Given the environment the LGPS exists in it is easy to understand why their levels of prudence are not as high as private sector schemes.  Perhaps there is no need for them to be.  After all they have the strongest possible sponsor, the government.  That the actuarial assumptions used are higher is therefore not surprising.  The report suggests that Benchmarking actuarial assumptions will lead to pressure for lower rates.  I am not convinced.  Benchmarking may even lead to a rise, as some local authorities may come to consider they have been unnecessarily prudent compared to the other LGPS funds and adjust their assumptions.  Equally benchmarking discount rates will still not give the full picture.  The actuarial methods used vary between actuarial firms, some, with particularly aggressive smoothing, use methods not even recommended by the Institute of Actuaries.  Consequently, even if the same actuarial assumptions were used, different deficit and contribution rates will still result.

This blog only argues that the current optimistic levels of prudence adopted by the LGPS are appropriate given the economic realities faced by local authorities.  It does not address the issue of whether there are benefits from merging the London borough funds.  Indeed I recognise that there should be significant economies of scale that could result.  However, I am not convinced that this will lead to the hoped for improvement in the strategic management of the funds and it may lead to a decline, but that is the subject for another blog.

The report makes generally unfavourable comparison between private sector schemes and the London boroughs.  Our own experience of reviewing the investment governance arrangements of private sector schemes, suggests that, whilst there are many examples of excellent governance, there is also a wide number of private schemes where similar governance issues to the LGPS exist, generally with similar causes.  Perhaps a more meaningful comparison for the long-term implications of the current management of the London borough schemes are the government’s unfunded schemes.  Any future shortfall in the LGPS will be trivial when compared to the unfunded liabilities of, for example, the state pension, civil service and teachers schemes.  Consequently, I would hope that they continue with their current, optimistic, approach to prudence and protect current services rather than sacrificing current service levels to protect against a longer term liability that may yet not materialise and, even if it does, may not be catastrophic, in the larger scheme of things.

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19th November 2012