Articles - Monitoring the cost of the LGPS

 By Matthew Paton, Associate and Senior Consulting Actuary at Barnett Waddingham

 If their valuation suggests that costs have risen or fallen significantly, then changes must be made to the Scheme to bring those costs back under control.

 Before we look at the main findings, it might be helpful to understand more about the origins of this process and its objectives. Please feel free to explore the interactive timeline below if you would like a recap.

 2010
 The incoming Government sets up the Independent Public Service Pensions Commission, chaired by Lord Hutton, to carry out a structural review of public service pension scheme provision. The aim is to ensure a fair sharing of risks and costs between members and the taxpayer.

 2011
 Lord Hutton recommends that public service schemes should move from a final salary benefit structure to one based on Career Average Revalued Earnings (CARE). To keep the schemes affordable and protect the taxpayer, each scheme should implement a cost “floor” and “ceiling” which, if breached, would lead to further changes being required.

 2013
 Many of Lord Hutton’s recommendations are enshrined in law by means of the Public Service Pensions Act 2013, including provisions for a “Cost Control Mechanism”, with a 2% corridor either side of the target cost, to be operated by the Treasury across the public service schemes.

 New LGPS regulations are laid to allow for the introduction of a CARE scheme. Running alongside the Treasury’s mechanism, the LGPS would also have its own, similar, “Cost Management Process” operated by the LGPS Scheme Advisory Board (the SAB). This would provide an early and more focused indication of any cost movements by including some of the unique features of the LGPS as well as being able to take some account of shifts in discount rates, allowing the SAB to recommend changes to the Scheme should they be necessary. Unlike the Treasury process where breaches require scheme changes, the SAB process operates a “must/should/may” approach to recommending changes depending on the extent of the change in costs.

 2014
 The new LGPS CARE scheme opens. Members start accruing benefits under the new structure, however transitional protections are built in so that older members benefit from a “statutory underpin”. This is to ensure the benefits they receive on retirement are no less than they would have been under the previous final salary structure.

 2018
 The inaugural cost management processes, based on scheme data at 31 March 2016, get underway. Early indications from the Treasury are that there may be significant floor breaches across all public service schemes including the LGPS. The SAB’s process also identifies an LGPS cost floor breach, in part due to a fall in life expectancies. They start work on recommending a package of benefit improvements to bring the cost back within the Treasury cost cap corridor.

 Elsewhere, the Court of Appeal rules that the transitional protections built into the CARE reforms amount to unlawful age discrimination. The ruling is known as the “McCloud judgement”, with the Government later committing to make changes to all of the public service schemes.

 2019
 Due to the uncertainties brought about by McCloud, the Chief Secretary to the Treasury, one Liz Truss, announces a pause to the Cost Control Mechanism, with the SAB announcing likewise for their own arrangements.

 2020
 The Government lifts the pause and announces that the cost of remedying the age discrimination - which would be achieved by extending underpin protection to younger members - is to be allowed for in the cost cap calculations.

 2021
 The SAB completes their own 2016 Cost Management Process and, after allowing for the cost of McCloud, no longer identifies a breach.

 2022
 The Treasury, which has the final say, announces the results of the 2016 Cost Control Mechanism. Similarly to the SAB’s process, no breach is found for the LGPS and no changes to scheme benefits are made.

 2023
 Trade Unions seek a High Court Judicial Review of the Government’s decision to include McCloud costs in the 2016 Cost Control Mechanism. The High Court sides with the Government and the challenge is unsuccessful.

 2024
 The case continues into 2024 in the Court of Appeal, which sides with the earlier ruling from the High Court. It remains to be seen whether Trade Unions will take further action.

 Lessons learned
 It is an understatement to say that that the 2016 cost cap process was not exactly a smooth experience and brought about some unintended consequences, so it is perhaps unsurprising that the Government felt some changes might be needed in terms of how it would operate going forward.

 Following a consultation, they announced technical changes to the operation of the Cost Control Mechanism for the 2020 valuations onwards. This reflected concerns that, after the initial 2016 breach, the mechanism was too volatile. The changes now make it less likely for a breach to occur, by excluding costs related to the legacy final salary schemes and by widening the acceptable range of costs. In addition, an “economic check” has been introduced which separately considers the impact of changes in the long-term economic outlook prior to considering any changes to the Scheme.

 Likewise, the SAB has introduced some analogous changes to its own process to ensure greater integration with the Treasury mechanism.

 Results of the 2020 cost cap valuations
 The SAB’s 2020 valuation has identified only a small deviation from the target cost of the Scheme, amounting to an increase of 1% of payroll. Being within an acceptable range, the SAB opted to not recommend any changes to the Scheme.

 Under a spruced-up methodology, the Treasury mechanism is now rather convoluted and operates in two stages.

 First, there is the “core cost”. This, being the main objective of the mechanism, assesses only changes in “member costs” and therefore excludes the costs of changes in long-term economic assumptions (which are instead met by employers through changes to contribution rates). The results of changes in the core cost are illustrated in the chart below. Note that, to avoid a breach, the total change must remain inside a 3% corridor, which is shaded in blue.

 Change in core costs

 As can be seen, by far the biggest contributor is the change in mortality assumptions. Even prior to Covid, there has been a trend of declining longevity improvements in the general population which has been reflected in lower life expectancies being assumed in this valuation. Further cost savings arise due to changes to “other demographic assumptions”, such as how much pension members are assumed to exchange for cash.

 The chart shows that there has been a slight breach of the cost floor, which previously would have been enough to trigger improvements to scheme benefits. Under the new approach however, and this is where the second stage of the process comes in, there is an “economic check”. The idea is that if the wider economic outlook has shifted, as this may have an impact on the financial health of the local authorities who ultimately underwrite the Scheme, then it would not always be appropriate to make changes to scheme benefits.

 Once the impact of the economic outlook is considered, the picture could not be more different:

 Change in costs including “economic check”

 Far from a breach of the cost floor, the economic check results in costs exceeding the cost ceiling. This is not unexpected given that the indicator of the economic outlook used in the calculation is the same as the discount rate used to set contributions in the unfunded schemes. This rate is referred to as the Superannuation Contributions Adjusted for Past Experience rate, or “SCAPE” rate for short, and has reduced enormously since the previous valuations, thereby causing spiralling contributions in those schemes.

 The logic of the Treasury’s economic check therefore becomes much clearer when we consider the unfunded schemes – if contributions are going up by so much then some might say it makes little sense to suggest that costs are going down and that the taxpayer is better off.

 Raising the offside flag
 A key feature of the economic check is that it may offset a breach but it cannot itself cause or contribute to one. In other words, it can act only to invalidate a breach. Perhaps think of it as a football referee raising the offside flag after a striker hits the back of the net. In this case, the fall in core costs suggests an initial change to the scoreline however, as the impact of the economic check completely wipes out the reduction in core costs, the flag is raised and the “goal” is disallowed.

 The upshot therefore is that the 2020 Cost Control Mechanism will not result in changes to scheme benefits and so, barring any further legal developments, it is a case of “as you were”. It’s worth remembering too that, unlike in the unfunded schemes, these results will have no bearing on the contributions that must be paid into the LGPS, which of course will be reviewed as part of the next triennial funding valuations.