LPFA's response to the Hutton Commission
A fair and affordable LGPS – LPFA’s proposals
The Remit
In your letter of 2nd July you ask for views on the following;
Affordability, fairness, impact on mobility and plurality of current public service provision of the current public sector pension schemes and;
The objectives that should guide public service pension in future.
‘In addition, as set out in the terms of reference, I have been asked to consider the case for delivering savings on public service pension ahead of the Government’s spending review. I would welcome any thoughts or observations on whether given the long term nature of structural reform there is a case for more immediate action on public service pensions, in the context of affordability and fairness, and if so, what options there might be to deliver savings within the spending review period.’
This paper also seeks address the terms of reference of the Commission which are;
To conduct a fundamental structural review of public service pension provision and to make recommendations to the Chancellor and Chief Secretary on pension arrangements that are sustainable and affordable in the long term, fair to both the public service workforce and the taxpayer and consistent with the fiscal challenges ahead, while protecting accrued rights.
In reaching its recommendations, the Commission is to have regard to:
the growing disparity between public service and private sector pension provision, in the context of the overall reward package – including the impact on labour market mobility between public and private sectors and pensions as a barrier to greater plurality of provision of public services;
the needs of public service employers in terms of recruitment and retention;
the need to ensure that future provision is fair across the workforce;
how risk should be shared between the taxpayer and employee;
which organisations should have access to public service schemes;
implementation and transitional arrangements for any recommendations; and
wider Government policy to encourage adequate saving for retirement and longer working lives.
The Response
LPFA have already made a significant contribution toward the debate via our green paper ‘a fair and affordable LGPS’ (attached). This paper promotes the concept of the independent pensions chamber to ‘take the politics out of pensions’ and ensure the future affordability of the scheme by adjusting, as required, for future increases in longevity and investment returns:
The benefit structure (e.g. accrual rates)
Employee contributions
Retirement age
Indexation
This paper aims to put that proposal into the context of the remit of the commission. Although we concentrate on the LGPS, as our area of experience and expertise, we believe similar principles are also applicable to the unfunded public sector schemes. The paper also identifies some quick wins that will contribute to the spending review and explores the options for a scheme that will meet the needs of taxpayers and members in the 21st century.
Quick wins
These should take the form of provisions which are as simple as possible to implement whilst having the maximum immediate impact on the liabilities and therefore employer contribution rates via the current valuation. All LGPS schemes in England are currently undergoing the statutory triennial valuation as at 31 March 2010. Changes announced now can be taken account of by actuaries so that the implications can be reflected in budgets for 2011/12.
First, cut the long-term liabilities of pension schemes, by announcing in September changes to the scheme effective from next April which actuaries can then take into account when determining the results of the current valuation. The lower the liabilities, the less the pressure to increase total contributions. The aim would be to keep total contributions at no more than current levels, and if possible, lower. Cuts in liabilities can be achieved through a cocktail of the following measures:
Application of CPI indexation to LGPS pensions in payment and deferred pensions – easy to put in place via the Pensions Increase order and can be taken into account this valuation. Already signalled by the Chancellor in the budget so no surprise. Overall, liabilities are likely to fall by an average 10% as a result of the change from RPI to CPI indexation
Increase in retirement age to 66 from 2016 in line with planned increases to State Retirement Ages, and linked thereto for the future. Again a minor amendment to regulations and not a surprise to anyone. Also many low paid staff will not be able to retire until they are eligible for their state pension so 66 will be the de facto retirement age for many
Adjustment of future accrual rates – say move to 65ths rather than 60ths. More controversial than the above and may be seen as tinkering prior to a new scheme being implemented
Cap on pensionable pay – limit to £75,000 or £100,000 – may be good politics and appease the unions but won’t save much money
Commitment to protect existing rights via a CPI indexed preserved benefit when introducing a revised scheme> – clarifies what is meant by retained rights but also allows actuaries to take a more certain view of the future cost of past service. Also ensures the issue is dealt with before discussions on a new scheme (* see paragraphs 16 to 19 for more on this matter)
Second, in the context of the spending review, immediately increase employee contributions and/or pare down tax breaks to reduce employer (taxpayer) contributions. Any increase in employee contributions should be skewed to protect low earners who might otherwise choose to opt out of the scheme.
The net result of implementing these proposals should be a reduction in employer contribution rates flowing from the results of the 2010 valuation and therefore an immediate effect in terms of local authority spending requirements for 2011/12 budgets and future years.
A new scheme
We have already suggested that a chamber be put in place to implement and maintain the LGPS but what kind of scheme could it be given the remit of the commission?
Affordability
There are two key elements here; firstly determine an objective benefit level that is affordable now, then ensure there are mechanisms in place to maintain that affordability without a long winded and politically vulnerable process. The first element is addressed by the quick wins identified above together with the proposals in the following paragraphs.
The second element, the continued affordability of the scheme, is addressed by LPFA’s suggestion of an independent chamber adjusting future contributions, benefits, retirement age and indexation to best meet the objectives of the scheme whilst remaining within predetermined affordability parameters.
Fairness
There are two aspects to this within the scheme and across industries. The first is dealt with by a move to Career Average rather than final salary, as the current final salary approach disproportionately benefits long serving high earners.
The second is less easy to deal with as the reduction in good private sector schemes in recent years has brought about a short term disparity between the private and public sectors. One point to bear in mind is the short term nature of the difference and that over the last 10 or 20 years the private sector package has been worth much more than that in the public sector.
However we must accept political reality and ensure that the gap between public and private sector provision is minimised. This will be achieved by the significant and understandable changes outlined in this paper.
The whole issue of the negative effects FRS17 has had on provision of decent pensions in the private sector (and on some employers within the LGPS) needs to be addressed. This is no doubt outside of the remit of the commission but is a major contributor to the disparity in pension provision. The use of spot interest rates to discount liabilities up to 60 years ahead is not logical and has had severe unintended consequences.
Mobility/Plurality
The question has often been raised of why there are so many schemes in the public sector and doesn’t this make it hard to move between areas within the sector? Of course some areas have different needs (e.g. fast accrual rates and excellent health benefits in the armed and uniformed services) but that alone cannot account for the myriad of schemes.
History no doubt plays a part, as has the treatment of retained rights which means that even if the new schemes are brought closer together, there would still be a legacy of retained benefits under different rules, so what is the point?
By crystallising retained rights via a preserved benefit, the issue of complexity can be removed (reducing long term administration costs as a side effect) and the costs capped. Using this method will enable schemes to move much closer together and could enable the merger of some of the non-fundedschemes, enabling greater mobility and reducing plurality.
The issue of retained rights is particularly important when considering significant changes to a pension scheme. Firstly unless the protection of such rights is clearly defined there will be confusion amongst the membership and the possibility of industrial action over what may appear to be semantics.
Secondly different definitions of protection will lead to different costs being carried forward into the new scheme. For example, protected service up to a date that will still have a benefit calculated on final salary is significantly more expensive than calculating the benefit at the preservation date then indexing its value by CPI. Even if the preserved benefit route is used, there remain questions such as should the original unreduced scheme retirement age apply to those benefits or that which applies to the new scheme?
LPFA’s view is that a strict definition of retained rights should be implemented reducing the uncertainty of future costs as much as possible. By doing so existing scheme members will make some contribution to the past service deficit which weighs so heavily on most funds. Also, such a ‘clean break’ approach will enable significant savings to be made on administration costs once the initial preserved benefit calculations have been completed.
Risk
Linked to the fairness issue, there is a question to what point, if any, should the taxpayer guarantee the benefits to be paid? At one extreme, a wholesale change to Defined Contribution arrangements could remove all risks to the taxpayer. However, we do not believe this is in the interests of scheme members or society as a whole. The answer should lie in the debate over what the minimum level of income in retirement should be which is good for society as a whole. Up to that point it makes sense for a taxpayer guarantee to be in place, beyond that the case is less easy to make if at all possible. Therefore some form of cap on the guaranteed element of the pension would seem sensible. Beyond that point the risk would fall entirely on the individual through top-up Defined Contribution arrangements or whatever other options they choose.
LPFA propose that the element of the benefit subject to taxpayer guarantee be limited to 50% of the pay between £10,000 and £75,000 per annum. The reasoning for the lower level is that the state pension already provides for roughly 50% of the first £10,000, so including that would be in effect be asking taxpayers to guarantee that income in retirement twice over.
The higher level is designed to provide a maximum guaranteed benefit (including state pension) broadly in line with the higher rate tax limit. To expect taxpayers to guarantee benefits which are greater than the higher rate tax bracket would seem unreasonable.
Objectives of the schemes
As stated above the core objective should be to provide a minimum income in retirement to ensure that individuals are able to enjoy a good standard of living without having to fall back on state benefits.
Beyond this minimum the schemes should be structured to provide an incentive to save for retirement without committing the taxpayer to unlimited costs. There are a number of different models for such a scheme and this is a good opportunity to address its appropriateness to the current workforce.
The scheme should be able to be marketed as a tax efficient saving scheme with extra benefits, thereby being more attractive to younger employees and potential recruits. Beyond the guaranteed core pension there could be a non-guaranteed top up pension, perhaps provided under a Collective Defined Contribution scheme. Also perhaps a choice of additional benefits would be more attractive and appropriate then the existing fixed elements. Such choices could include;
Additional non-guaranteed pension
Death cover
Health cover at different levels
Health benefits (e.g. annual medical check, subsidised gym membership)
Partner’s pension
Children’s pension
Redundancy cover
Early retirement option
Early lump sum drawdown
Assignment for mortgage purposes
The benefits would be individually costed with the member and/or the employer being able to pay additional amounts for any combination of optional elements. Changes to the elements selected would be allowed as the member’s needs change through their career.
The inclusion of new items such as early lump sum drawdown (say a maximum of 10% of total value of the pension pot) and assignment for mortgage purposes (of the amount above the guaranteed minimum) would make the scheme more attractive as they enable use of benefits earlier when they may be of better use to the member (e.g. when having to fund university fees or to reduce mortgage costs).
Implementation and transition
The implementation tasks and timetable would be as follows;
September 2010 recommend quick win changes to the scheme
October to January draw up Statutory Instrument’s required for above
February make recommendations for new CARE scheme (with core guaranteed element, non guaranteed top up plus optional elements) and Pensions Chamber to maintain affordability
April 2011 publish regulations and implement quick wins
Remainder of 2011 negotiations, legislation and formation of chamber, preparation of administration system changes and member information
April 2012 new scheme regulations published, chamber in place
Summary
In summary, LPFA believes that the LGPS needs to change in order to deliver a decent pension that is fair on the taxpayer, relevant to the needs of members in the 21st century and affordable in the long term. The paper attached outlines our proposals for achieving this aim and I commend it to you.
In terms of the other public sector schemes, LPFA would prefer to see similar principles also applied across the unfunded schemes. Ideally we would wish to see all new entrants having the option to join a funded scheme to provide a guaranteed appropriate level of benefits, with the option to choose other arrangements to top-up savings as they choose.
London Pensions Fund Authority July 2010