Assuming no political intervention, September’s CPI announcement will result in a 10.1% increase in LGPS benefits next April. Robbie McInroy discusses the implications for local government pension funds.
For the Local Government Pension Scheme (LGPS) and its employers, the September inflation figure is particularly meaningful as it is normally used to determine the pension increase for the following year. Therefore, today’s (19 October) announcement from the Office for National Statistics – of a record 10.1% increase in the Consumer Prices Index (CPI) – gives rise to many different considerations for LGPS funds. This is particularly the case when we have all been so used to low and predictable inflation over a prolonged period.
Assuming that the September inflation measure continues to set the following year’s pension increase order (this may be a big assumption given recent hearsay coming out of Downing Street about the state pension triple-lock), LGPS benefits will increase by 10.1% from April 2023. This means both current pensions in payment and the Career Average Revalued Earnings (CARE) benefits of active and deferred members.
It is important to recognise that once these benefits have increased by 10.1% they will not reduce from there (again, bravely assuming there will be no political intervention). The two immediate and obvious knock-on effects of this are: (i) more cash is needed sooner to pay pensions; and (ii) an increase in liabilities.
Assuming that the September inflation measure continues to set the following year’s pension increase order, LGPS benefits will increase by 10.1% from April 2023.
Focus on cashflows and liquidity
Historically, benefits from LGPS funds have been paid from the contribution income received, with any excess contributions being invested. In the last few years most LGPS funds have reached the “tipping point” in the natural evolution of a funded pension scheme where benefits match or slightly exceed contribution income. The 10.1% benefit increase in 2023 brings forward this tipping point, or further increases any existing gap between benefits and contributions.
This is also likely to be exacerbated on the contribution income side by lower than inflationary pay increases, drops in staff numbers from opt-outs as the cost-of-living crisis bites and/or possible workforce restructuring.
This is not an issue in itself (the billions of pounds of assets held by the LGPS are there for the purpose of paying benefits) so long as it is managed and monitored. To inform planning and decision-making, it will be important to have up-to-date cashflow forecasting under a range of inflationary best-estimate and stress test scenarios.
Impact on a fund’s liabilities
Higher benefit payments mean fund liabilities will also be higher. The 2022 LGPS valuations are currently taking place and inflation has been a significant talking point. Higher short-term inflation will have been factored into the actuarial assumptions used for the valuation. However, there remains considerable uncertainty about how long high inflation will persist.
If inflation, and pension increases, are higher for longer than current assumptions, then there will be a higher-than-expected increase in liabilities at future valuations. All else being equal (which is perhaps unlikely given the impact inflation can also have on asset values), this means the funding level will drop. However, the LGPS has time on its side given its open nature. For most employers, it can take a long-term view to manage this type of short-term volatility and avoid it derailing existing funding plans.
There are employers where the volatility will be more of an issue – those that will only participate in the LGPS for a shorter period. These employers can’t take a long-term view and are more exposed to the short-term uncertainty and volatility. Therefore, funds will need to carefully consider their funding plans and ensure this higher element of risk is incorporated. This could take the form of factoring changes in inflationary conditions since 31 March 2022 into negotiations over contribution rates (within a framework that is more responsive to changing conditions) and committing to regular ongoing reviews instead of waiting for the statutory three-year review.
Mitigating high inflation
While higher inflation pushes up the value of liabilities, LGPS funds are also invested in asset classes that would be expected to provide a good level of protection against sustained periods of higher inflation. However, a specific analysis of the investment strategy is likely to be helpful to understand the full extent of inflation exposure, the current levels of mitigation and if any changes are needed.
A key driver to any actions will be the time horizon over which inflation causes the largest risk to funds. While liquidity will need to be managed, the open-ended nature of LGPS liabilities mean the largest risk for most funds might stem from inflation remaining higher for longer. This will make it more challenging to earn a long-term rate of return above inflation – generally a key requirement of LGPS investment strategies.
It will therefore be crucial to avoid knee-jerk reactions to shorter-term conditions which could make it harder to achieve the longer-term requirements.
After a decade of very low inflation and against the current backdrop of market uncertainty, there is much for the LGPS to do to quickly grasp and navigate the emerging issues.
Operational issues
Inflationary uncertainty and market volatility are also impacting on governance and administration functions. In the last month, covering the fluid situation and emerging issues has created increased workloads and activity for officers and advisers. The key is to ensure adequate extra time and planning to allow fuller information and analysis to be factored into decision-making.
On administration too, already under-pressure teams are likely to see increased activity from the high inflationary environment and cost-of-living crisis – including increased member queries, communications, opt-outs, early retirement quotes, scam activity and tax implications.
The above has touched on some of the areas impacted by high inflation and pension increases. After a decade of very low inflation and against the current backdrop of market uncertainty, there is much for the LGPS to do to quickly grasp and navigate the emerging issues.
Robbie McInroy is a partner and LGPS fund actuary at Hymans Robertson.
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