With many LGPS funds now reporting surpluses and the funding problems for local authorities showing no sign of improvement, calls are mounting to review pension contribution rates. Elizabeth Carey, an independent adviser and research analyst for Local Government Pension Schemes argues that this could be short-sighted.
The funding crisis hitting local councils has many root causes too complex to describe in this article. Understandably, councils are feeling pressure to reduce their employer LGPS contributions as a way of cutting budget expenditures.
What seems like an easy short-term “fix”, however, threatens the long-term viability of the whole LGPS system if it erodes the funding covenant between pension funds and employers. Instead, a sustainable, affordable and inter-generationally fair LGPS system requires a funding plan that takes greater account of the needs of employers and recognises that contribution rates cannot simply be raised every three years to “make the numbers work”. Short-term wheezes or financial engineering proposals (like partial exits for still-open plans) are gimmicks that disregard longer-term affordability and inter-generational fairness. The real solution lies in a balanced and sustainable funding strategy that intentionally preserves affordability and inter-generational fairness. At the heart of any such funding strategy is continuing to invest in return-seeking assets that deliver compound returns in excess of the actuarial discount rate, thereby building up capital for the future.
Why must “fully funded” LGPS portfolios continue to focus on generating returns?
There are two main sources of ongoing payments into LGPS funds. One is contributions from current employers and employees; and the other is total returns on investment portfolios arising from interest, dividends and/or capital gains.
With many LGPS funds at or above a calculated funding ratio of 100%, some advisors are calling for funds to “de-risk” and focus more on generating cash returns to match current payments to pensioners. For demographic reasons, a “de-risk” mentality amounts to looking backwards through the proverbial telescope. It risks steering LGPS funds onto a financial sandbar, metaphorically speaking.
I argued in an earlier Room 151 article, LGPS funding adequacy: Is 150% the new 100%? – Room 151, that today’s 100% funding amount may not be sufficient to meet pension promises longer term. The reason is rooted in the maturity profile of many LGPS funds: over time, the number of members in receipt of pensions will exceed the number of active employees generating contributions into schemes, while the average payment (based on career average salary) to a retiree exceeds the average contribution by/on behalf of active members who, as a group, are younger and less advanced in their careers. Each young new employee joining an LGPS scheme immediately adds to that employer’s funding liability amount. Future benefits over a full career can be readily calculated now, whereas investment returns on contributions related to that employee aggregate over the several decades until he/she reaches retirement age.
Many LGPS funds are already cash flow negative, paying out in benefits more than they receive in contributions. Negative cash flow as a percentage of assets tends to rise over time, which eats into fund assets unless continuously offset by positive investment returns. For LGPS plans that are still open to new members—like those of councils—this poses a potential funding risk longer term if investment returns do not make up the shortfall. For most employers of still open plans, the ever greater need for compounding investment returns means that their LGPS funds must remain return-seeking. Risk reduction should come from diversification rather than shunting allocations towards coupon-clipping assets. Moreover, what used to be considered “safer” assets, namely index-linked gilts or high quality bonds, proved to be anything but safe over 2022 and 2023 thanks to interest rate hikes and the mini-budget débacle.
Look at funding from the employer’s viewpoint
When designing their strategic asset allocations, fund officers, advisors and actuaries should expressly consider the employer’s viewpoint, and hence prioritise longer-term affordability of primary and secondary contribution rates. If the priority is to keep contributions as low as mathematically possible, then it follows that fund assets, as a whole, will need to “work harder”. Assets must generate returns at levels above the actuarial discount rate, while observing sensible liquidity, diversification and other risk management parameters. Fortunately, many opportunities present themselves now more attractively priced in the current investment environment.
Except in cases of closed schemes or full exits, so-called “de-risking” strategies may be storing up funding pressures for future LGPS members, potentially making their contribution rates unaffordable in years to come. And for obvious reasons, “partial exit” proposals create moral hazard because they would transfer the benefits of years of collective investment returns to existing deferred and retired members—whose own contributions (while active members) were lowered by investment returns on contributions relating to previous generations—while piling the financial burden of funding their retirement onto current and future active members and their employers. Such a scheme is grossly unfair from an intergenerational standpoint, and increases funding risk for current and future active members and employers. The only clear winners of partial exit schemes appear to be advisors who would doubtless charge fees for implementing such a questionable “service”.
So, rather than focus on short-term measures, working LGPS investment portfolios harder, while expressly seeking to keep contribution rates as low as possible, may be the most affordable way to preserve fairness across generations of LGPS members and employers alike.
Elizabeth Carey is an independent adviser and research analyst for Local Government Pension Schemes. The opinions expressed in this article are the author’s own and not necessarily those of any clients or other parties.
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