Results from the triennial valuation of LGPS are beginning to emerge. Barry McKay argues they show a scheme where an increase in assets and decrease in liabilities means things are looking better.
The results are in. We are nearing the end of the 2016 formal valuations and the majority of English and Welsh LGPS funds will have their results. Inevitably, there will be various commentators questioning whether the LGPS is sustainable. From the results so far, it looks to be a very positive story for the LGPS.
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Financial health
Firstly, the funding level (the ratio of assets to liabilities) has increased materially since 2013. Every LGPS fund will have had a different experience but, for a fund that Hymans advises, funding levels are up by 7% on average.
This is a fantastic result in what has been a challenging and changing environment, which seems to be omnipresent in the LGPS, characterised by lots of uncertainty and unexpected events (Brexit and Mr Trump spring to mind).
There are several reasons (typically) for these pleasing results:
- Increase in assets
a. strong investment performance over the 3 year period from 2013 to 2016 that in general exceeds the expected return; and
b. funds paying deficit contributions to meet their objective of being fully funded and meeting the benefits falling due - Decrease in liabilities
a. favourable membership experience for the fund (although not for the member) over the last 3 years. In particular, a low pay growth and low inflation environment, which increases benefits less than expected
b. an expectation that these economic conditions will continue in the future. This has been factored into the 2016 valuation assumptions
However, there is an expectation that economic growth will be lower for longer in the future. Many commentators agree that this is likely to lead to lower investment returns for the next few decades than funds have experienced in the past few. This pushes up the cost of future benefits materially — and this is not captured by the cost management mechanism.
Pooling and a move towards lower investment fees will help but funds need to consider how to generate their required returns to help keep contributions affordable.
Required investment return
Speaking of required returns, more good news is that analysis we carried out evidences the LGPS is holding more assets per £ of pension in 2016 than in 2013.
This means, assuming contributions remain at current levels, the average return required on the assets held by the LGPS has reduced from 5.0% p.a. at 2013, to 4.5% p.a. at 2016. The required return is the estimate of what the assets need to deliver every year to ensure the LGPS has enough money to pay all the benefits that have been promised to members.
The investment bar has been lowered and this places less reliance on investment returns than before. Again, very positive news for the LGPS.
If funds can continue to return in excess of the lower target of 4.5% p.a. then the financial health of the LGPS will continue to improve. We may even see contribution rates for the major employers reducing for the first time in many years. Given LGPS funding has been materially reduced in recent years this would be a very welcome break for funds.
Better employer outcomes
It is far more difficult to comment on trends in contribution levels due to the large number and diversity of employers now in the LGPS funds. Every employer has its own contribution rate calculated in accordance with the fund’s funding strategy statement, and allowing for the specific characteristics of the employer.
We adopt a forward looking approach when setting contributions for all employers, as opposed to the alternative which is backwards looking, discounting benefits which relies on subjective assumptions.
Instead, we project the employer’s assets and benefits into the future and test whether a given contribution level and the current assets are sufficient to meet all the pensions to be paid. This also allows the employer’s strength of covenant to be taken into account, an area where there is more scrutiny nowadays.
The result is that each employer should have a contribution plan that aligns with their funding objectives and investment strategy to maximise the likelihood of meeting their obligations.
Conclusions
The LGPS has become inherently more complex due to the proliferation and diversity of employers within funds. That brings understandable challenges, particularly during the valuation season.
And that’s in the context of increased economic uncertainty and an unrelenting charge of change for LGPS — investment pooling is a prime example. Fortunately, there are more solutions available to funds that can make their lives easier during these challenging times, driven by technology and innovative approaches being devised by the advisory community in conjunction with the funds.
We’re seeing increasing numbers embrace these innovations. This will help them get through the next three years and beyond in even better shape.
Dr Barry McKay is a partner at pensions adviser Hymans Robertson.
