A Place in the Sun?: Public Finance

Posted on October 31, 2008 · Posted in Public Finance

As the global financial crisis deepens, public sector pension schemes are facing a double whammy. Not only are they suffering from falling share values, but there are increasing calls for their ‘generous’ retirement benefits to be curtailed. Paul Gosling investigates

Public sector pensions make a surprising topic for newspaper headlines, but they have increasingly grabbed them in recent weeks. They could even be an important issue in the next general election, with a growing chorus of chants that they are over-generous and unfair in comparison with the private sector.

In addition, say critics ranging from business leaders to the Daily Mail, the acknowledged problems of public sector schemes are in danger of becoming crises. Potential liabilities on unfunded schemes might have reached £1,000bn and even the funded local government schemes are finding it difficult to meet liabilities, as they become squeezed by an ageing population and falling stock market returns.

The time has come, say the critics, to ask whether public sector pensions, in their current form, have become unaffordable. The public sector, it is suggested, should copy business by offering much more restricted and cheaper schemes.

One of the immediate problems is that local government pension schemes are more heavily invested in equities than are private sector schemes, and are consequently more affected by falling share values.

Tim Sharples, partner at pension actuaries Lane, Clark and Peacock, believes that local government schemes’ deficits have grown significantly in recent months. He estimates that where asset values matched approximately 85% of liabilities last year, this has now fallen to about 75%.

Local authorities therefore face a growing prospect of having to increase contributions after the next valuations in 2010, which would mean either raising council taxes or cutting services.

In one of the largest schemes, Strathclyde, its assets have fallen in value from £9.5bn to £8.5bn in the past six months – a drop of 10.5%. Of this, a staggering £700m was lost in the past three months. Another of the largest funds, Lothian, recorded an 8.8% fall in value from April to the end of September.

For Strathclyde, the good news is that the fund has not gone into deficit. It has also avoided contamination from ‘toxic assets’, an estimated $300bn of which may be owned by other pension schemes globally.

A spokesman for Glasgow City Council, which administers the Strathclyde scheme, says: ‘We wouldn’t necessarily say the fund is exposed to toxic assets, however, losses from any specific company are overshadowed by losses from overall market movements. All pension funds will be affected in this way, but local authority funds generally, and Strathclyde specifically, maintain above-average equity allocations, so are likely to be more exposed than most.’

The spokesman adds that the fund runs a ‘globally diversified investment strategy’, with 18 investment portfolios, and owns some 3,000 lines of stock in more than 50 countries. While this means it has direct investments in many companies, it also limits dependence on the performance of any individual institution. ‘It is unusual for the fund to have exposure to more than 0.5% to any company,’ he says.

Strathclyde has a small exposure to the Icelandic banks. It doesn’t have any money deposited, the spokesman says, but does have a £4.09m bond with Glitner, purchased on its behalf by Western Asset. ‘This represents less than 0.05% of the value of the fund and presents no risk whatsoever to present or future pensions,’ he adds.

One legal adviser to local authorities told Public Finance that it is widely rumoured that many local government pension funds have, like local authorities, held funds in Icelandic banks. Sharples shares this assessment. ‘If they have taken the same sort of approach as local authorities, then one would expect them to have some [loans and deposits with Icelandic banks],’ he says. CIPFA has commissioned a survey of funds to find out actual exposure levels to the Icelandic banks.

There are also fears that some local government schemes might have made losses through investing a small, but growing, proportion of their funds in hedge funds in recent years – just at the wrong time. Although the national newspapers have been full of reports of hedge funds and their investors reaping massive returns from short-selling bank shares, the reality is that the hedge fund sector has, generally, just had its worst year since 1990.

But some of the largest local government funds have avoided hedge funds. Mike Taylor, chief executive of the London Pensions Fund Authority, explains: ‘We are not invested in any hedge funds as a matter of policy. We don’t like the fees or the lack of transparency. And we don’t have a penny in any Icelandic banks, although we have a very small exposure to Icelandic investments within a pooled fund.’

Neither has the fund any direct investments in toxic assets. There is ‘a small level of exposure through pooled funds but we are not aware of anything significant and we have gone through it’, he says. The LPFA has also suffered less damage to its assets from recent events than most other UK schemes, because it invests in equities internationally, with only about 10%–12% of its holdings in UK shares, explains Taylor.

One approach taken by the LPFA and other schemes is to carefully review exposure to ‘counterparty’ risks, checking whether they could bear losses if third-party institutions they have contracts with fail or default. This has led the LPFA to suspend all stock lending until November, because of possible questions of stock ownership where shares are loaned. Strathclyde and other funds have adopted a similar approach.

Despite the severe damage inflicted on Strathclyde and other public sector pension funds, the worst could be yet to come as the ‘discount rates’ that measure liabilities fall and liabilities consequently rise. Pension fund liabilities are measured in today’s money, but with a ‘discount’ that is calculated on the basis of what that money will be worth by the time the liabilities are drawn upon, and reduced further in line with returns on double-A rated bonds. The discount rate for government pension schemes increased from 1.8% to 2.5% in March this year, reducing liabilities and the impact of stock market falls. Even marginal changes to the discount rate can increase public sector liabilities by £100bn or more.

But as base rates are cut in the coming weeks, discount rates will fall and pension fund liabilities rise. Even worse, the UK’s Accounting Standards Board is considering responses to a discussion paper that proposed replacing the existing use of the rates earned by AA bonds with a more conservative ‘risk-free’ rate, which would have the effect of reducing the discount rate and increasing liabilities for local government schemes.

Despite the anxieties, it would be wrong to be over-pessimistic about the prospects for local government pension funds, stresses CIPFA. Bob Summers, head of the institute’s pensions panel, says: ‘The next scheme valuations in England and Wales will take place as at March 31, 2010, at which time future contribution rates will be discussed. There is therefore no immediate requirement for council tax rises or service cuts to pay for additional contributions as a direct consequence of any decline in asset values in LGPS funds. We are 18 months away from a valuation and there are a wide range of factors that will affect the outcome of those valuations, such as interest rate movements, price and wage inflation and corporate bond yields. It’s far too early to conclude that increased contribution rates are a given.’

Councils are anyway in a much better situation than most of the public sector because the Local Government Pension Scheme is funded. This means that its funds are invested, with pensions paid from the returns on those investments.

Most other public sector schemes – of which there are an amazing 30,000 to 40,000, according to analysis from Parliament’s scrutiny unit – are unfunded and must meet liabilities from their revenue budgets. Many of the schemes have been reformed in recent years, with most changing the retirement age from 60 to 65. However, at the same time this has typically risen to 70 in the private sector. There have also been moves to make staff share some of the risk of schemes, for example, by reducing the opportunities for early retirement.

There are calls for further reforms and for cuts in the financial support given to public sector schemes. October’s report from the Pensions Policy Institute showed that the reforms to date have reduced the value of schemes for workers and future pensioners, but that these effects have been marginal in comparison with those in the private sector.

The average value of public sector schemes following the reforms have fallen from 24% to 21% of salary for new entrants – still above the average value of a private sector defined benefits scheme. And there has been a big shift away from the use of defined benefit – mostly final salary – schemes in the private sector, towards money purchase schemes, in which staff bear investment risks. This move has not been replicated in the public sector.

Consequently, the reforms have not reduced the cost of public sector pensions, which must bear the burden of higher longevity. The PPI calculates that while private sector employers contribute £1,600 per member of staff per year towards their pension, public sector bodies provide an average of £4,000 per employee.

Niki Cleal, director of PPI, explains: ‘Our figures suggest the annual cost of public sector pension schemes is rising from around 1% of gross domestic product now to 1.4% by 2028. That is a 40% increase in that period. And it is a faster rate of growth than other areas of government expenditure for which figures are available, including for health care. But you have to keep it in context. It’s [only] up to about 1.5% of GDP.’

However, she adds: ‘It’s a different question to answer whether the country can afford that.’

It is also wrong to overstate the impact of the current crisis on public sector pension schemes, she says. ‘Actually, because most of the public sector schemes are unfunded, most of the current schemes are not themselves affected,’ she explains. ‘The exception is local government. Local authority schemes will, like all private sector schemes, have seen reductions in their value because of the stock market falls.

‘But pensions are a long-term savings vehicle. And any impact will depend on whether the stock markets recover and we don’t know right now. So we need to keep this in perspective.’

However, David Davison, a director at actuaries Spence and Partners, says: ‘What we have developed now is a two-tier pension system. We have very different scenarios in the private and public sectors. A recent survey from [pension consultants] Aon showed that only about 17% of private sector [final salary] schemes remain open to new employees. We have already seen a move to money purchase type arrangements.’

Davison adds that at the same time, public sector pay has become competitive against the private sector, removing the need for a more generous public sector scheme to recruit and retain staff. Remuneration incentives now risk creating a ‘brain drain’ from the private to the public sectors, he believes. ‘That makes it even less sustainable,’ he suggests, especially given the current pressures on public spending. ‘There is such a huge extreme in difference in the level of benefits.’

The CBI business lobby has been doing its own analysis over the summer to estimate the size of the unfunded public sector pension liabilities, which was officially valued at £850bn (also including deficits in local government schemes) at March 2007. Neil Carberry, head of pensions, says: ‘On a very conservative estimate the liability is £920bn. We think it is around about £1trn[£1,000bn].’

Those future liabilities could become a major campaigning issue for the CBI. Carberry stresses that given the fact that business is one of the major groups of taxpayers, this is an issue of legitimate concern. Further, some CBI members that compete for public service contracts argue that public sector pensions are a hidden subsidy to direct labour. They suggest that it would cost them an extra 21% of salaries to match scheme conditions offered by the NHS, which NHS employers pay just 14% towards.

At the very least, after the next general election, public sector pensions are likely to be closely examined by an incoming government.

But before then, there is another hurdle for the current government to overcome. The fall in equity values also affects individuals’ personal pension plans and even, possibly, the viability of much of the insurance sector. There are growing fears that having bailed out the banks, the government could yet have to do the same with insurers, which manage many pension funds. Company pension schemes seem to be effectively protected by two safety nets – the Financial Services Compensation Scheme, or the Pension Protection Fund. There are, though, fears that there could be demands for the government to provide support if with-profits pension funds collapse.

More worryingly still, the government underwrote various pension schemes when some formerly state-owned businesses were privatised. BT’s liabilities, for example, could be as much as £3bn. In addition, the Post Office – now back on the agenda for privatisation – has a pension fund deficit of almost £4bn and growing, which the government might have to plug. Declining share values also threaten the viability of a range of pension schemes and personal savings vehicles, such as equity ISAs, on which retirement earnings were planned.

The very foundations of Margaret Thatcher’s economic revolution – the end of nationalisations and the creation of a ‘shareholder democracy’ – now look equally at risk.