Estimated reading time: 3 minutes
Barry McKay explains why it is important for LGPS Funds to have a policy in place to deal with the risk of ill health retirement.
Most LGPS benefits build up gradually during each member’s employment. However, if a member retires early as a result of ill-health, it might not just be the member that is laid low; the employer’s funding position may also be feeling down.
Ill-health retirements can cause an immediate strain on finances as the individual may receive a pension, assuming membership continued to retirement (under Tier 1 ill-health). This causes a timing mismatch of contributions and benefits. Funds will have made some provision through their regular contributions but the pension has now been brought forward and enhanced.
"For small or medium sized employers, these contributions can be very small relative to the strain cost of even a single ill-health retirement. For example, an employer with 100 employees and a payroll of £2m might set aside £30k p.a. However it’s quite possible that an ill-health retirement could cost £300,000,* so that’s 10 years of contributions used up!"
For small employers with only 10 employees and contributions set aside of £3k p.a. the same scenario could leave them feeling very unwell! So what can funds do to ensure their employers are fit and healthy? There are several options to mitigate or transfer this risk.
The traditional approach to minimising these risks would be to pool small employers and share experience to spread the risk. Pooling in this way is a fairly simple approach which reduces these risks for individual employers but also pools all other risks. This option may be appropriate for employers with similar characteristics and in the same sector but may not be suitable where employers can take their own decisions; for example, salary increases.
Another option is to insure the ill-health benefit with an insurance company. This mitigates the risk to the employer as they pay a premium to the insurer and in return the insurer will pay the strain cost resulting from an ill-health retirement. Policies can be set up for the whole fund, a group of employers (e.g. academies only) or offered as an employer choice. The premium will vary depending on what type of policy is chosen, the type and number of employers and the past experience of the fund.
There are a number of advantages of this approach. Apart from the risk being transferred to the insurer, the premium paid for insurance could be deducted from the employer contribution rate so that the amount paid by the employer is unaffected. However, this will result in less money going into the fund.
The disadvantage, however, like any insurance product, is that there will of course be a loading for the insurer’s expenses and profit and the fund will need to consider cost versus benefit.
Unlike conventional pooling, self-insurance can be used to target specific risks, particularly those that employers have no control over, so that experience is averaged across the whole fund (or across a group of employers). This is actually very similar to the fund acting as a mutual insurer for these risks.
This approach smooths the potential volatile experience across the whole fund or large group of employers. This is particularly beneficial for small and medium sized employers as it achieves the same expected contribution rates as currently and can be put in place without the involvement of any external parties.
Self-insurance has a number of advantages:
- “Premiums” are just the expected cost of the ill-health benefits within the contribution rate, if experience is broadly as expected, so the fund and employers are unaffected
- Achieves a more stable contribution rate but maintains each employer’s responsibility for other risks (e.g. salary increases)
- The administration should be more straightforward than with external insurance
- Removes the risk of the employer failing as a result of an unaffordable strain cost
- Carrying out the additional calculations as part of the valuation means that they can be done efficiently
There are other policy and funding decisions that will be required. For example, what should the initial “premium” be and should this be the same for all employers? What happens to any premiums paid if an employer leaves the fund? How should the money be invested?
*Note: based on a member earning £30k retiring at age 45 on Tier 1 IH
The key is to have a policy in place to help employers stay (financially) fit and healthy. The 2019 valuation is a good opportunity to carry out a health check and Barnett Waddingham can help you with the financial wellbeing of your employers, working through the above issues and administering a self-insurance approach.