The end is nigh – for final salary schemes: Local Government Chronicle

Local government’s final salary pension scheme will cease to exist within four years. That is the dramatic prediction of authorities’ own pension fund managers and other senior council finance officials.

A survey of participants at recent seminars organised by fund advisers Mercer found that 75% believe that the current final salary scheme will not exist by 2012. Most senior managers believe that the final salary defined benefits scheme will be replaced by an average earnings defined benefits scheme. Some 70 pension managers attended the events, representing most local authority pension funds.

Change is apparently inevitable, because the Government insists that a cost sharing mechanism must be established – agreed, if not actually up and running – by April next year. The Government says that the LGPS must be sustainable on a long-term basis, without taxpayer support, despite the demographic pressures and the risk that equities will not provide sufficient growth in values.

Formal consultations will begin this autumn on proposals for change. However, it is unclear what level of flexibility there will be for individual schemes to operate their own cost sharing arrangements. The Department of Communities and Local Government’s discussion document refers to there not being a “formulaic” approach, but the need for “a shared approach”. Given that different schemes have different funding strategies, there may be flexibility permitted for local schemes in addressing likely funding shortfalls.

But at present it is unclear the extent to which there will be a single cost sharing arrangement. A spokeswoman for DCLG says: “There will be a single, national LGPS approach which will apply, as necessary, to the circumstances of each LGPS pension fund authority in England and Wales.” Unison opposes a single national approach and insists that scheme savings, as well as extra costs, should be shared. It also insists that extra costs caused by poor investment returns are solely the responsibility of the employers’ side to address.

Cost sharing arrangements could include higher levels of employer and employee contributions, delayed retirement and changes to the nature of defined benefits. Chris Hull, head of Mercer’s Local Government Consulting Unit, who chaired the recent seminars, says: “Cost sharing will be a vital negotiating area for LGPS over the next few years. Implementing a fair and effective cost-sharing system is a difficult task for any pension scheme. However, it’s particularly difficult for a national scheme like LGPS in which thousands of different employers participate.”

What is not an option, says Hull, is avoiding change. “The Government is committed to taking forward cost sharing,” he says. “It’s said it must happen.”

Over half of Mercer’s seminar attendees suggested that cost sharing should apply to benefits and retirement age, but almost half believing that only employee contribution adjustments should be made. Three quarters of delegates thought that it was employers’ responsibility to address the results of shortfalls on investment returns. Nearly as many supported the idea that extra costs caused by increased longevity should be funded by employees. But only 7% thought the scheme would move to defined contribution.

Alison Murray, a partner and actuary in fund advisers Hyman Robertson’s public sector team, says that she is not surprised by predictions that defined benefits in the future will be based on average rather than final salaries. “We did a survey a couple of years ago and our result was that career average was actually more appropriate for a lot of the membership,” she says.

Murray suggests that a final salary scheme suited the type of people who used to make up the majority of scheme members – senior male staff, who rose quickly through the ranks. But subsequently, more manual, more low-paid and more part-time workers belong to LGPS and the current arrangements are less appropriate for them. Pensions based on average pay suit these members better.

Average pay can also help more members to retire gradually – for the benefit of both employers and employees. While there are provision for flexibility beyond the agreed retirement date, Murray believes the complexity of these provisions puts off too many people.

Charles Cotton, the Chartered Institute of Personnel and Management’s reward and employment conditions adviser, shares the view that moving towards defined benefits based on average salaries could be very positive. “There are a number of advantages of moving to career average,” says Cotton. “One is that it can help you cut the cost, while retaining defined benefits. It can be beneficial for those employees who want to slow down at the end of their career, or who have gone part-time. Staff don’t feel forced to take the highest salary before the end of their career.”

However, Cotton warns, trade unions are likely to resist changes to the current system. “On the one hand you have the cost pressure, on the other you have union strength, which is often vocal in support of existing arrangements,” he says. But he adds, unions may in the end decide that protecting some form of defined benefits is more important than risking going to defined contributions.

There is, though, scepticism about whether any serious change to LGPS will actually come about. David Coats, associate director of the Work Foundation – a think-tank that considers employment trends – accepts that changes to average salaries will probably need to come, but not yet. “Tesco has put together an average salary scheme, which has been negotiated with the trade unions,” Coats explains. “But I wonder whether there is a real appetite for renegotiation of the Local Government Pension Scheme, given that it has only just been renegotiated. You have to ask who these managers are and what they were asked.”

Coats agrees that in the long-term defined benefits will move towards using average not final salaries, and that there will be a much more gradual evolution for workers into retirement. But, says Coats, we are not there yet. “At some point we will have to look at building in some measure of flexibility,” he says. “It is not a pressing issue. It’s a 20 year, not a four year, programme. I don’t see the appetite for dramatic change.”

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The private sector challenge

The Local Government Pension Scheme must also face up to the challenge of how to accommodate increasing numbers of employees of private and third sector employers, who have won fixed term contracts for local authority clients, says Hyman Robertson’s Alison Murray. Traditionally, the LGPS has been heavily invested in equities and, to a lesser extent, property. But volatility in the valuation of these asset classes (especially at present) can be difficult for fixed-term contractors to cope with. The start and end of a five year contract, for instance, could coincide with a peak and a trough in equity values that would have the effect of creating long-term liabilities for a contractor that wipe-out the profits from the service contract. Murray believes that, as a result, the LGPS must also consider governance arrangements and parallel investment strategies that suit employers who have shorter-term commitments than does local government itself.