Articles - Are there any silver linings from the McCloud case

Many employers in England and Wales will now know the pension contributions they are required to pay for the next three years, effective from 1 April 2020, following the results of the 2019 formal valuation. However, it’s not out of the question that these contributions could increase before we even reach the next valuation.This is because of the costs associated with the McCloud and Sargeant age discrimination cases in the judges' and firefighters' pension schemes.

 By Barry McKay FFA, Partner and Fund Actuary at Barnett Waddingham

 As well as the benefit changes that may consequently fall out of the cost management process, we continue to work under a (Mc)cloud of uncertainty.

 An update is provided below, without any more weather related puns (until at least the end of the article!).

 Background to the changes in public sector pension schemes
 Based on the recommendations of the Hutton report, all public sector pension schemes were reformed in 2015 and benefits were changed going forwards. Alongside this, transitional provisions were introduced with the laudable aim of ensuring that any changes would not impact those members closest to retirement.

 However, these protections were deemed to be unlawful on the grounds of age discrimination. Although the Government applied to the Supreme Court to appeal this decision, this was denied on 27 June 2019.

 While the judgements are not about the Local Government Pension Scheme (LGPS), as rulings in public sector schemes, it has been confirmed that a remedy will need to be made across all public sector schemes.

 Why will LGPS costs increase?
 In the case of the LGPS, transitional protections were put in place for those members within ten years of retirement, when the benefits changed from 31 March 2014 (2015 in Scotland). These protections effectively act as an underpin and. as any remedy has to ‘level-up’ benefits between the current benefit structure and the underpin for a potentially wider group of people, this will inevitably increase costs for LGPS employers.

 Although the remedy is still unknown, is it likely that protections will apply to all members who were active on 31 March 2012 and the period of protection could be extended past ten years.  

 What will the increase in costs be?
 In short, we don’t yet know what the cost will be. The remedy is yet to be agreed and there will be associated implementation costs. There have been a number of estimates that vary from zero to double digits (as a percentage of liabilities), although it should be noted that this is on employer level. On a Scheme level, the range is much smaller.

 There are a number of decisions to be made on how levelling up will be applied and these will impact the cost. The simplest solution would be to extend the current protections to all members. Given the improvements in accrual rate (from a 1/60th to a 1/49th) and the low pay growth environment relative to inflation since the introduction of the 2014 Career Average Revalued Earnings (CARE) Scheme, you would expect the additional cost to be relatively small. This is because, for the majority of members, the protections will not bite.

 However, there are a number of options that could be considered and these may lead to an increased cost:
 Protections may apply for all future service of eligible members or some other defined period but extended beyond ten years
 Members who have left but then re-join may be eligible for protections
 Protections apply to all benefits (e.g. survivor benefits, transfers, pension sharing on divorce) and not just pension
 Other reasons why LGPS costs may rise
 Apart from the protection period, one of the main drivers of the expected cost will be long-term pay growth. The Government Actuary’s Department (GAD) has carried out estimates of the cost based on long-term pay growth of CPI plus 1.5%. Using this assumption and a prudent view of member eligibility, GAD estimated the additional cost to increase employer contributions by 3% of pay (and increase active member liabilities by 3.2% of pay).
 Actual pay growth has been considerably lower than this since the introduction of the 2014 CARE Scheme. These estimates of the potential cost of protections are therefore higher than if actual pay was used. However, if the protections were to apply for all future service and long-term pay growth does pick up again, the additional costs could be material. This will also vary by employer due to different membership profiles.
 Where historic benefits are revisited, there may also be some knock-on effects on tax paid if previous annual allowance estimates change, for example.
 Cost is clearly a big issue. But a bigger concern may be how the agreed remedy is implemented. It would be a disappointing outcome if the Scheme spends more on administering the remedy than the actual cost of the remedy. 
 How has this been allowed for in the 2019 valuation results?
 Although we don’t know what the remedy will be, there was an expectation that administering authorities would discuss with their Fund actuary and consider what allowance should be made for the potential cost of McCloud in their valuation results. This expectation was documented here in para 10.iii. The regulations also require the fund actuary to consider the solvency and long-term cost efficiency of the Scheme which is an important consideration here.
 Typically this has been allowed for through a more prudent discount rate than would otherwise be the case, although other approaches are possible. The increase in cost will depend on the level of prudence taken, as well as the long-term pay assumption and individual employer profile. So, it is not helpful to give an average but the increase to contributions will typically be in the range 0.0% to 1.5% of pay using this approach.
 Alternatively, an explicit addition could be made to the employer contribution rate which may need to take into account the membership profile of each employer. Or an asset reserve could be set aside to meet future costs once the remedy is known. Or indeed a fund could justify doing nothing due to the uncertainty surrounding the remedy!
 It is likely that the latter option will be picked up as part of the independent review of the actuarial valuations of the LGPS funds undertaken by GAD under Section 13 of the Public Service Pensions Act 2013.
 Whatever approach has been taken, this should be disclosed in the Funding Strategy Statement as GAD will be looking at these documents closely as part of their review under Section 13. 
 What happened to the cost cap?
 The cost cap is a mechanism that was also introduced following recommendations in the Hutton report. The aim was to ensure that the cost of the public sector schemes remained affordable and sustainable in the long term.
 In theory, the cost cap process is a completely separate issue. However as they both will affect the level of future benefits, the cost cap process has been paused until a remedy is determined. Before McCloud, the initial calculations carried out by the LGPS Scheme Advisory Board (SAB) inferred that the cost of the Scheme had reduced, largely as a result of the slowing down of future improvements in life expectancies. Therefore, member benefits would need to be improved.
 Initial thoughts were to reduce employee contributions at the lower pay bands, enhance early retirement terms, remove the Tier 3 ill-health benefit and introduce a minimum death-in-service lump sum. Broadly, if the overall cost of the McCloud remedy is more than the reduction in the Scheme cost then the cost cap will not be triggered this time.
 However, if McCloud costs less than the reduction then the cost cap process is back on the table and will result in benefit improvements. This is assuming that any remedy will be considered in the cost cap calculations. 
 What happens next?
 In short, we are struggling to find any silver linings to McCloud. It is likely we will not know how it's going to impact the LGPS for some time yet – probably next summer at the earliest – so the sky may be somewhat hazy until then! SAB has asked us to cost various options to help with the decision making process for the McCloud remedy. We are also going to participate in the working group to implement any changes.
 In the meantime, it may be beneficial for administering authorities to raise awareness with employers around the current uncertainties. Administering authorities will need to communicate and ensure employers make the certified contributions effective from 1 April 2020 and all stakeholders await further information.  

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