Why contribution stability matters in the Local Government Pension Scheme

Local Government Pension Scheme (LGPS) authorities are keen to maintain the stability of contributions to their funds. This makes sense. But at the same time, funding levels over the long term have allegedly shifted to the point that the scheme is vastly overfunded, while local authorities are struggling to pay for frontline services. 

Questions are coming from all directions, including industry members and honourable members of the House of Lords.

It would seem, say some, to make sense to reduce employer contributions, redirecting that money to key services. It feels difficult to argue against when funding numbers of 140% to 170% plus, for some funds,  are quoted to back up the argument. 

Behind the numbers

The high funding levels quoted come from assessing the value of liabilities in the LGPS using gilt yields as a proxy for the ‘risk free rate’, a measure used extensively across the insurance market and private sector pension funds. The model used by LGPS funds to assess their liabilities allows for an allocation to growth assets. The discount rate is an estimate of the long-term return based on the portfolio of assets a fund holds or based on a gilt yield, adjusted for pension risks. In current market conditions the LGPS model can produce a lower discount rate than the private sector approach which results in higher employer contributions. 

So just by shifting the measure to gilt yields we could indeed push the value of liabilities down and release those funds back to employers through lower contributions. Savings of up to £6bn per year have been quoted in some quarters, a figure which could indeed make a real difference to front line services.

A word of caution

On the face of it this appears a sensible course of action releasing funds to where they are most needed and, in many ways, it is an argument I could fervently support given the enormous financial strain local authorities are under. I would ask however that we pause and cast our minds back a mere six years. At that time many net discount rates were similar to where they are now, but gilt yields were significantly lower. 

Discount Rates in the Local Government Pension Scheme: An intergenerational fairness perspective, a report published for the Intergenerational Foundation in March 2020 also used gilt yields to assess LGPS liabilities but put forward an argument that couldn’t be further from the one currently being promoted. The report claimed that the scheme was significantly underfunded (to the tune of £185bn rather than the £35bn shown in LGPS valuations). It went on to argue that employer deficit contributions needed to rise from £2bn to some £12bn per year to avoid such a burden being passed onto future generations. Again, on the face of it this appeared a sensible course of action ensuring that future tax payers wouldn’t have to pick up the tab for current profligacy.

Finding a sensible way forward

I have no reason to doubt the sincerity, veracity or arithmetic of those who promote either the current argument or the one posed six years ago, but is a £14bn shift over just six years really the sort of volatility in contributions that scheme employers would welcome? Do LGPS employers really want the volatility associated with the Teachers’ Pension Scheme where employer contributions have increased from 16.5% of pay in 2019 to 28.5% of pay currently? 

Perhaps there is some wisdom in the desire for stability.