By Melanie Durrant, Partner and Public Sector Consulting Actuary, Barnett Waddingham
Investment returns from LGPS pension fund assets have been a mixed bag over the three years since the 2022 actuarial valuation. While some funds have done better than expected, others performed less well.
Pension increases of the non-salary linked and non-GMP benefits (which make up most of the benefits) have been much higher than anticipated, being 10.1% in 2023 and 6.7% in 2024. While the 2025 increase was only 1.7%, total benefits have still increased by almost 20% since 2022. It is important to remind ourselves that this increase is permanent. Every single benefit payment made in the future will be 20% higher than it was in 2022.
All else being equal, pension increases alone would reduce funding levels by about 8%. With that in mind, let’s clarify some of the most common misconceptions circulating at the moment.
Are LGPS funds sitting on huge surpluses?
Some funds have been reporting very high funding levels which in some cases have reached over 200%, effectively saying the fund has twice the money needed to pay for all member benefits accrued to date. However, these skyrocketing funding levels are not matched by skyrocketing asset returns over the last three years. Instead, the main driver is changes to actuarial assumptions.
To determine how much money a fund requires, the actuaries need to make an assumption about future investment returns. If expected returns are assumed to be high in the future then less money is required to be held by the fund today, which in turn reduces the contributions required from the participating employers.
Some actuarial models link expectations around future returns to current gilt yields, particularly when the actual assets held by the fund are expected to achieve a return greater than what the government is currently offering. While this might feel intuitively correct, this approach has three crucial disadvantages:
Gilt yields can be very volatile and did indeed increase dramatically since the 2022 valuation – leading to inflated, unrealistic, and unstable funding levels.
LGPS funds are predominantly invested in growth assets like global equities, which have little to no correlation with UK gilt yields, leading to a mismatch between funds’ actual investment performance and long-term outlook.
In these models, the equity assumption is calculated as a fixed amount above gilt yields. So, as gilt yields have increased over the intervaluation period by around 3%, funds will now be banking on equities returning on average 3% p.a. more than before, despite the economic outlook being much more uncertain than three years ago.
This does not mean gilts-based models are inherently wrong, but funds need to understand their drawbacks and more importantly, take the good news about large surpluses with a pinch of salt. If expected returns don’t materialise, the current estimated surpluses could disappear as quickly as they have arrived.
Should contribution rates be dramatically cut?
With local councils under severe budget pressure and large surpluses being reported, it is not surprising that some employers have been anticipating significant contribution reductions (with some suggestions stating possible employer contribution rates of single digit figures, as far down as 6%).
While we believe there is scope to reduce contributions at the 2025 valuation, any significant reduction would be a short-sighted and could potentially bear severe risks:
Undermining stability: The desire to maintain stable contribution rates is part of the fundamental regulations underlying the LGPS and should therefore not be ignored.
Complicating long-term planning: Abandoning the goal of stability will make long-term planning for employers harder. A strong but short three-year relief could be followed by an uncertain future, heavily depending on shifts in the global financial climate.
Increasing reliance on future investment returns: Paying lower contribution rates now puts more reliance on future investment returns, which are more uncertain than ever.
Employers paying less than member contributions (reputational risk): Member contributions are set in legislation and cannot be reduced. Members are likely to be dissatisfied if they are paying more than employers.
Intergenerational fairness: Any future adverse experience would be picked up by future generations and taxpayers.
Section 13: The Government Actuary’s Department (GAD) will review the employer contributions agreed following the 2025 valuation. They have made it clear that they will be looking at funds in a surplus position more closely, but we do not expect them to look favourably on funds that release surplus too quickly.
While local councils are the backbone of the LGPS, the scheme includes a wide range of employers in different financial positions and with different anticipated time horizons in the LGPS. Therefore, contribution rates must be tailored accordingly.
Are all LGPS funds in the same position?
Absolutely not. The overall objective – ensuring the security of members’ benefits while maximising investment returns to remain cost effective – is the same for all funds, but their approach to achieving this goal differs. Moreover, whether a fund is considered to have a large surplus very much depends on the approach to setting the actuarial assumptions, as discussed above.
Generally, any broad-brush analysis that does not take the funds’ funding and investment strategy into account should be treated with a lot of caution.
At Barnett Waddingham, we use a funding model that links expected investment returns to each fund’s actual investment strategy, not gilt yields. This has led to more stable and realistic funding levels, giving our clients confidence that any reductions in contributions are sustainable and remain affordable, not based on potentially overly optimistic projections.
So, is there any good news?
Yes, plenty. The LGPS still finds itself in a fundamentally strong position. Compared to unfunded schemes like the Police or Firefighters’ Pension Schemes, it enjoys:
lower and more affordable contribution rates;
a growing base of assets; and
less exposure to demographic risk, thanks to being funded.
Going into the 2025 valuation, the scheme’s resilience has allowed it to remain cost-effective while continuing to protect members’ benefits. However, that strength depends on avoiding short-term thinking which jeopardises long-term stability for momentary gains. We need to take this opportunity to ensure the future sustainability of the scheme, in an environment where there is a significant pensions adequacy problem.
The LGPS is a rare success story in the public pension landscape - let’s ensure it stays that way.
|
