Michael Johnson is a research fellow at the Centre for Policy Studies. His the Local Government Pension Scheme: a death spiral beckons has been published today by the CPS.

Successive governments, irrespective of political hue, have, for decades, acted with irresponsible abandon when making provision for their own staff’s pensions.  Pension promises have historically been worth roughly 35 per cent of salary, yet contributions have been only around 21 per cent: pure Madoff economics.

Lord Hutton’s reforms (moving pensions from a final salary, onto a career average, basis, effective from April 2014) will not rescue public service pensions.  Transitional protection given to anyone within ten years of retirement (“grandfathering”), a last minute conciliation to the unions, renders the reform largely impotent, although there could be significant long-term savings…..but far too late.  This did not stop Danny Alexander, Chief Secretary to the Treasury, stating to the House of Commons “I believe that we will have a deal that can endure for at least 25 years, and hopefully longer.”  This shuts the door on any (near term) scope for further negotiations concerning benefits, notwithstanding Lord Hutton’s subsequent reservations about his own proposals: “what we’ve seen is how very quickly the assumptions which underpinned my assessments of the long-term sustainability of public service pensions have been shown to be too optimistic. That is going to affect the sustainability of public sector pensions in a negative way.”  It would appear that the inequality between public and private sector pensions will continue to evolve, and with it, societal division.

Some 85 per cent of public service pensions are unfunded (i.e. with no underlying assets): they are under the radar of the kind of scrutiny experienced by funded schemes.  Harbouring behavioural risk, notably the temptation to defer some of today’s employment costs (fuelling generational inequality), they have no need to adhere to any cashflow discipline.  Last year the Treasury had to plug a £10.5 billion cashflow gap between contributions and unfunded pension payments: five years hence, the Office for Budget Responsibility’s expects it to be £16.2 billion, and rising rapidly.  And that is after Lord Hutton’s reforms.  Unfunded (pay-as-you-go) schemes mask a classic case of kicking the can down the road.

Meanwhile, the other 15 per cent of public sector workers are in funded schemes, dominated by the Local Government Pension Scheme (LGPS).  With over £200 billion of assets and 5.2 million members (active, deferred and pensioners: more than 10 per cent of all adults in the UK), it matters.  To-date, it has been cashflow positive, but that will soon change, because the drivers of costs and income are wholly misaligned.  Contributions are shrinking relative to pension payments, care of an ageing membership (the LGPS is “mature”), a situation exacerbated by pensions remaining indexed to inflation while pay is frozen (so contributions do not grow), as well as declining asset-derived income (due to low interest rates).

The LGPS comprises a disparate collection of 101 opaque, predominately sub-scale funds, with excessive costs and abysmally lax governance.   Consequently, they are delivering sub-optimal performance, and all the funds are underfunded.  Over the next few months each individual funds will publish its annual report for 2012-13.  These are likely to confirm that their financial health is continuing to deteriorate, with the very weakest funds consuming (i.e. selling) assets simply to meet pensions in payment.  With no realistic prospect of recovery, they are probably in a death spiral, heading to an unfunded status.  To be clear, this observation is based upon cashflow, not nebulous concepts such as funding ratios, which do not manifest themselves in day-to-day life…..and thus do not exert much political pressure.  That could change, however, once people connect deteriorating local services with a pensions-derived cashflow squeeze.  Last year, in England, local government employers paid £5.7 billion to LGPS pensions, equivalent to 26 per cent of the £22.4 billion collected in council tax.  Scottish employers paid contributions of over £1 billion, equivalent to 54 per cent of the £1.9 billion collected in local tax.

So, what to do?  Benefits aside, the LGPS is, operationally, woefully inefficient.  This could be addressed, in three simple steps:

  1. Improve transparency, and adopt widespread standardisation, essential prerequisites for the digitisation required to centralise all LGPS administration.  Such an initiative would require a huge cultural change within the Department for Communities and Local Government (DCLG) and the LGPS, but silos have to be broken: the cloud has transformed everything.   We can no longer simply design for today’s cultural norms.  The LGPS’s expensive, paper-based, administration is in need of transformation;
  2. Redesign the investment process, emphasising investment in passive, not actively managed, funds. Almost all investment management should be brought in-house; today’s reliance, for example, on external management to invest £9 billion in private equity is an extraordinary exhibition of profligacy and missed opportunity; and
  3. Facilitate fund mergers, preferably using a dramatically improved governance framework.  This could require each LGPS fund to conduct annual tests to evidence that their members are not disadvantaged by a lack of scale in assets or membership.  Funds that fail such tests could be required to merge, which would best serve members’ interests.

Each step has a common theme: cutting costs, by harnessing economies of scale.  Costs are controllable, whereas investment performance, by and large, is not.  This necessitates structural change.

Based upon evidence drawn from some of the world’s most efficient public pension funds, and allied databases, a restructured LGPS should be able to cut costs by at least £860 million per year.  The LGPS needs no more than six separate (regional) funds, each with some £35 billion of assets, competing with one another to deliver the best service to members, using a common central administration platform.  In time, they would become “expert clients” capable of extracting best value from the financial services industry, and enjoying the many other benefits of scaling up.

To the extent that economies of scale reduce funds’ costs, they would help address deficits.  This is a theme that the UK pensions industry has repeatedly tried to ignore: scaling up is not in its interests, but it is very much in the interests of scheme members.  There is also a political dimension to consider: scaling up could imply centralisation, which conflicts with localism.  This strikes at the heart of an unwritten democratic settlement: the allocation of power between local and central government.  In addition, change would require confronting inconvenient truths and entrenched vested interests.  Some service providers would, for example, experience a contraction in their client bases, and a reduction in administration headcount would be inevitable.

That said, support for fund consolidation would come from across the political spectrum, as well as from many within the public sector unions: they understand that fund mergers would best serve the interests of their membership.  Reduced costs (akin to improved fund performance) could be used to slowly restore funds’ financial health, as well as potentially leaving some scope for sharing the benefits between members and employers through, for example, lower contributions.  By reconfiguring the LGPS, the DCLG would be demonstrating leadership, which would resonate with the Chancellor’s recent call for greater ambition and a “can do” attitude.

In addition, DCLG would be setting an example to the myriad of sub-scale private sector occupational pension schemes, encouraging them to also scale up, perhaps clustered around particular industries.  This would force the retirement savings industry to confront its own inefficiency.  It is no longer “cutting edge”, a point reiterated in the recent publication of the Mercer Global Pension Index.  This scores each country on the adequacy, sustainability and integrity of its publically funded and private pension systems.  The UK has now fallen to 9th place, way behind the leaders (Denmark, the Netherlands and Australia).  This has serious implications for the UK’s economic competitiveness, given that our financial services are (currently) a major export industry.

There is an underlying objective.  The UK desperately needs to catalyse a savings culture, both to fuel economic growth, through investment, and to encourage our ageing population to provide more for themselves in retirement.  This requires them engaging with an under-performing retirement savings industry that is in the Last Chance Saloon of public opinion.  Restructuring the LGPS provides the Government with an opportunity to demonstrate to the industry how to deliver an occupational pension scheme fit for the 21st century.

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