By Mark Wilson, Principal at Mercer
But a lot can change in a short period, and in many cases, these exit deficits have fallen dramatically, with surpluses emerging as the discount rates that typically drive them increased due to higher interest rates. This good news story poses a new set of questions for the LGPS that many Funds are now considering.
What if there is a termination surplus?
With preparations underway for the 2025 valuations, and the recent Government announcement allowing private sector scheme to more easily access surplus, the spotlight on these issues in the LGPS is only going to increase. So, review of the termination approach is a key area, to ensure Funds have a robust policy that manages both risk and costs and balances the needs of different employers. This is something Funds should be considering now.
Tier 3 exits – a recent (difficult) history:
Historically, tier 3 deficits were largely calculated with reference to the yields (or price) of Gilts or corporate bonds to provide “insurance” against future deficits emerging, akin to what is seen in the private sector in buy-in/out transactions.
The idea was Funds could invest in these low-risk assets when an employer exits and use them to meet the exiting employer’s future benefit payments. The aim was to provide the remaining benefits with relatively low financial risk to other employers, given the Fund can no longer call on the outgoing employer for additional funding. So, this was an estimate of the “market value” of exit – the market cost of the risk passing from outgoing employer to Fund.
And for many years prior to 2022, these yields were very low which meaning a high price for reducing the risk, resulting in unaffordable exit costs. And so in some cases employers were trapped in a scheme they could not afford (see our recent article on the charity sector here).
This also led in some cases to Funds having to consider in detail exits that did occur – being forced to answer the question what can the exiting employer afford? Employer debts were a given, surpluses a far-off fantasy, and protecting the other employers in the Fund had to be balanced against affordability for the outgoing employer.
What a difference a budget makes
Now that headline may be a little simplistic – interest rates were already rising prior to the November 2022 budget, and this has continued across the world, with interest rates materially higher than the prevailing “norms” of the previous 10-15 years. But as we are now well past the second anniversary of that budget, it is useful to consider what has changed.
An important consequence is that exit costs are generally much lower and, in some instances, there are surpluses, which could potentially mean exit credits are payable. This leads to important questions for Funds – in particular, in what circumstances is it right to pay exit credits and is our policy appropriately robust given the fiduciary duty to taxpayers and other employers?
One viewpoint is Funds should pay out surpluses rarely if ever – “this is public money, why would we pay it to private organisations”? This maybe a perfectly valid approach but does it apply in all circumstances? Should the amount of exit credit be limited? Often the decision can depend on the specific circumstances of an employer and the reasons they have participated in the Fund.
But many tier 3 employers have been in the Fund a long-time, their assets arise largely / totally from their own contributions, and they provide some public service – education, social housing, charity. And, crucially, they are responsible for their own pension costs and risks until they exit. So, given they provided the funds and bore the risk to this point, it is reasonable to ask should they not receive this?
Is a shift in focus needed?
The way to consider this potentially difficult issue is by answering a slightly different question – what does the Fund need to ensure as far as possible there will be sufficient monies to provide the benefits to the former members, with a suitable margin for risk?
This is key for an LGPS Fund, and answering this question should ultimately decide the size of any deficit payment or exit credit. The final payment naturally catches the eye – we can be talking very large cash sums, many millions in some cases. But by focussing on the total assets that are left behind – the level of protection for the taxpayers and other employers ultimately – Funds can be sure they are fulfilling their primary responsibilities in a balanced and equitable way.
Of course, “how much does the Fund need?”, is a difficult question, with a wide range of potential answers linked to the view on future risks. Funds can come up with different, equally valid approaches, depending on their views on a range of uncertainties – inflation levels, mortality rates, scheme expenses, asset transition costs, and on and on.
Here actual insurance costs for private sector schemes are a useful policy benchmark – ultimately the insurance cost is the “market value” of the risk being transferred – and there is a lot of data available to consider this. Here Funds can apply a simple “Goldilocks” test to the assets left behind on exit:
If they are too far below the insurance cost, is the Fund (and the taxpayer) sufficiently protected?
If they are too far above the insurance cost, is the risk being managed efficiently?
If the policy approach strays too far in either direction, then employers may reasonably ask why. While there may well be good reasons, testing existing policies in the current environment will be key in ensuring your approach is robust, equitable for all parties and ensure Funds are protecting taxpayers and ultimately the members left behind.
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