LGPS: Valuations and the hard reality of contributions

LGPS funds are waiting for the 2016 valuations. Urrffa Rafiq explores the best method for valuation and asks how the estimated aggregate deficit of £100bn will be managed.

Valuations could mean facing “hard reality”. Document from Government Actuary’s Department.

We wait with bated breath for the results of the 2016 actuarial valuation of the Local Government Pension Scheme (LGPS) in England and Wales, especially as so much has changed over the three years since the last valuation – investment market conditions, regulations and the increased level of government scrutiny.

As a reminder, at a national level, the aggregate deficit at the 31 March 2013 actuarial valuation was £47bn which, based on KPMG estimates, has increased to around £70bn as at 31 March 2016 and is now over £100bn. These estimates use an approach where liabilities are pegged to gilt prices, which was used by the majority of LGPS funds back in 2013. As a consequence of gilt yields being so low, pension scheme liabilities have risen and have stepped up to all-time highs since the Brexit vote.

With limited evidence to suggest a reversal, the actuarial profession is scratching its collective head about what this means for the amount of cash needed by pension schemes. Is it still right to use a discount rate pegged to gilt yields and if so, should the expected return above gilts remain the same?  If not, what are the alternatives and are they any more appropriate?

Contributions crunch

It is about now that local authorities are being given an indication by their pension fund of the new level of contributions required for the three years from April 2017 . Perhaps surprisingly, we have heard that some funds are not asking for significantly higher contributions.  With a gilts-based deficit that has more than doubled and future service costs increasing by nearly 50%, this raises some clear questions about the approach the LGPS actuaries are choosing to take this time around. (Just after this article was submitted West Midlands requested an extra £100m in contributions this year).

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The first point to note is that a lot of the increase in liabilities has happened since the actuarial valuation snapshot date of 31 March 2016, so it might be that some of the challenges are being deferred until the next valuation. Whilst markets might improve between now and 2019, you would be lucky if you were to bet on it and be proved right.

Secondly, unless they are simply concluding that deficits don’t need to be repaid in full, it follows that a rationale has been developed for higher discount rates (which give lower liabilities). And indeed, most LGPS funds are going to use a discount rate based on inflation (CPI) plus an assumption for the real return on assets.

This is neat and drives a stable future service cost because benefit increases are in line with CPI. However, the question is whether this provides any better indication of asset returns over the short and long-term. Finance theory would suggest that asset returns will reflect the level of risk over and above a risk-free rate, and although years of evidence does not suggest a significant level of correlation, the correlation between returns and price inflation is no better.

Where a pension fund is intending to sell its liabilities, there is broad consensus that funding should be tied to gilt yields – this is how insurance companies price pensions.  However, given that a sale is not on the cards, there is greater flexibility around how the liabilities can be measured.

Indeed, one might argue that funding doesn’t matter at all if the covenant from the employers is 100% — and some consider that there is, in effect, such a strong covenant in local government.

That said, given the legal uncertainty around the crown guarantee for the LGPS, and what would happen if a local authority were to fail, allowing too much flexibility could lead, in effect, to partial funding. It’s also important to remember that a quarter of all LGPS fund liabilities relate to employers that do not have tax raising powers and so this is not a “one-size-fits-all” issue.

Hard reality

So, is affordability the tail wagging actuarial dog? Whichever way you cut this actuarial valuation, if the results suggest that local authorities have to pay more, then it will simply not be affordable for most – so finding a presentable valuation approach has become the priority.

At the last actuarial valuation market conditions improved significantly between 31 March 2013 and the following September, and this was used to mitigate contribution increases. At this valuation, the new discount rate methodology will not reflect the increase in liabilities assessed using a gilts basis since 31 March 2016.

However, if presentation is put to one side, the harder reality comes to the fore. Across the LGPS we estimate there are around £1 trillion of earned pension payments, but only £250bn of assets to meet them. All extra contributions are welcome of course, but the key to the future of the LGPS is devising a long-term investment strategy which best finds a balance between risk and return.

Urrffa Rafiq, is a director and public service pensions and local government lead at KPMG UK.

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