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2004 Solvency Levels - FRS17/Funding
Chris Chadwick, a partner in the Cheltenham office, looks at the recent history of local government pension scheme FRS17 and funding solvency levels.
Readers of our November issue will recall that Barnett Waddingham have been keeping an eye on the development of the assets and liabilities of a typical local government fund with a solvency level of 90% at 31 March 2001. This "typical" fund has assets invested 50% in the FT - Actuaries All Share Index, 30% in the FTSE All World ex UK All Share Index and the remainder in the FT Actuaries UK Fixed Interest Index.
In this issue we follow the notional fund through to 31 March 2004 - the statutory valuation date for funds in England, Wales and Northern Ireland. For convenience, the initial position at 31 March 2001 is restated for the model scheme in table 1, together with hypothetical FRS17 figures at that date on the public sector 3½% real discount rate basis.
The pensionable payroll in the model scheme was £210m, giving rise to a deficit contribution of 5% of payroll.
The UK equity market recovered somewhat from its nadir on 12 March 2003 over the course of 2003 so the figures at 31 March 2004 in table 2 below are a little better than those at 31 March 2003, which will help both in setting council tax levels from 1 April 2005 and in reducing (slightly) the headlines in local papers prompted by the FRS17 deficits.
Review
The most striking feature of the above is still the wide swings in the solvency ratios over such a short period, reflecting the equity bias of the asset portfolio as compared to the liabilities. Although the pre-retirement discount rate adopted in the funding basis takes account of the yield available on UK equities, falls in yields on corporate bonds over the period tended to reduce the funding level and so limit the range of the gap between the Funding and FRS17 solvency results to 7-11%. As can be seen from the graph below, gloom and doom still dominate events since the last round of actuarial valuations in England and Wales in March 2001. However, both the funding and FRS numbers have maintained the levels seen at the end of October, without getting significantly better since.
In broad terms the main message is a fall of around 20% from 2001 to 2004 in solvency levels on either basis. If written off over 13 years, the additional contribution rate required over and above that already in payment might be around 7.5% of payroll, over 20 years it might be 5%, and over 40 years 3.5%. The corresponding increases in Council Tax would then be of the order of 20%, 12.5% and 10%. Even the lowest level of increase is unlikely to be easily swallowed by council taxpayers in view of the storm of publicity likely to attend the "early warning" FRS17 valuation results at 31 March 2004 that will be published in summer 2004 in Councils' accounts. It is to be hoped that the nationwide effect will be built into central government's standard spending assessments, though this is likely to turn out to be wishful thinking! Unfortunately the hoped for 10% rebound on the markets turned out to be only 4%, of which about half corresponded to the change of yields, so significant rises seem inevitable, even if longer and longer amortisation periods are employed.
Footnote
It has recently been suggested in some quarters that the employer contribution rate payable to a funded public sector pension scheme, such as the LGPS, should never exceed the ultimate net cashflow of the scheme. Here the "ultimate net cashflow" means benefit outgo less member contributions received once the scheme has matured and membership (pensioners, deferreds and actives) settled down into a steady demographic profile.
The rationale for such an assertion is that it would not be worth pre-funding a pension scheme where the investment returns were so poor that the employer cost was more than this figure. Instead the employer could simply pay the contributions out of cashflow and save the difference. In the long term, this is of course true on average over the years once the demographic steady state has been achieved. However, even if the LGPS is taken to be "mature" enough for this purpose, contribution rates over the 15 years since pension increases became funded have clearly averaged significantly less that this "ultimate net cashflow" figure, which is likely to be in the 25-30% range. On this measure the high rates required at the moment are simply catching up on previous low levels of contribution, prompted by a realisation that too much credit may have been taken for (equity) investment returns in setting contribution rates in the past.
Chris Chadwick, April 2004.