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ITEM PF14

PENSION FUND COMMITTEE – 26 NOVEMBER 2004

FACING THE FUTURE – PROPOSITIONS AND PRINCIPLES FOR AN AFFORDABLE AND SUSTAINABLE LOCAL GOVERNMENT PENSION SCHEME

Report by the Head of Finance & Procurement

1. The Government published the above titled consultation document on 4 October 2004. As the title says, the document is not a set of actual proposals, but a series of principles and propositions for taking the LGPS forward. The Government are keen that the document is fully considered, to enable detailed proposals to be published during 2005, and has therefore set the deadline for consultation responses as 31 March 2005.
2. This Committee will need to form a view on the consultation document in so far as the principles and propositions will impact on the long term future of the LGPS and the Oxfordshire Pension Fund. As Administering Authority, this Committee also has a role to promote discussion and response on this document amongst the Fund’s employers, and their employees. Employers will need to comment on issues of the long term future of the scheme, but also on how the changes will impact on the recruitment and retention of staff in their service areas. The detailed consultation arrangements are covered in the next steps section at the end of this report.
3. The Government is committed to retaining the LGPS as a funded, defined benefit, final salary scheme, but only if it can be demonstrated to be affordable and sustainable. It is looking to balance the benefits payable to members, with the costs incurred by stakeholders, whilst ensuring that the scheme remains a key tool in the recruitment and retention of staff to the public services. The Government is also looking to redress the balance in funding the scheme between the employee and their employer.
4. The Government is looking to ensure that the new scheme going forward is appropriate for the modern era, and reflects a more flexible approach to work, and the changes in society. The scheme needs to reflect the fact that people are living longer than ever before, that the ratio between those actively employed, and those retired is steadily declining, and the need to support partners and dependents in numerous ways outside the traditional marital home.
5. The consultation document needs to be seen in the context of the changes already implemented or proposed by the Government. This document is viewed by the ODPM as the third phase of their current stocktake. The two previous phases have been aimed at stabilising the affordability of the current scheme, with phase three now looking to ensure the sustainability into the future. The key aspects of the first two phases have been the increase from 50 to 55 in the minimum age from which benefits become payable, and the move to fixing the standard retirement age at 65, through the abolition of the 85 year rule. A further key change has been the introduction of the new flexibilities within the development of Funding Strategy Statements, and the exhortation from the ODPM to maximise the prudential spreading and phasing of any past service deficits, taking into account the long term future of local government, and the regulatory requirement to maintain employer contribution rates as near stable as possible.

Key Components of the Consultation Document

6. The consultation document is based on the closing of the current scheme (except for existing pensioners, and those with deferred benefits), and the transfer of all active members to a new look LGPS. The new scheme would contain what was seen as best practice from the old scheme, plus a series of new, relevant and flexible elements. The new scheme would be open to the same staff groups as the existing scheme.
7. There are a number of key components of the consultation document. These are as follows:

• An accrual rate of 1/62.5 of salary. This is marginally better than the current actuarial calculated rate of 1/64 of salary, which comprises 1/80 in terms of annual pension, plus 3/80 lump sum payment.
• The removal of the automatic lump sum (currently paid at 3/80 of final salary for each year’s service). In future, a retiring member would be able to elect to receive up to 25% of their pension entitlement by way of a lump sum payment. Each £1 of annual pension would equate to £12 if taken as part of a lump sum.
• A variable employee contribution rate. The ODPM approach here is to create greater equity between member payments and benefits received. As employees receive tax relief on their contributions, those in higher tax brackets are paying a lower proportion towards their final benefits, than those in the lower tax brackets. The consultation document shows by way of illustration, possible employee contribution rates based on salary bands, as follows:

• A new Defined Contribution Scheme. The consultation document argues that the introduction of a defined contribution scheme would alleviate the need to offer an Additional Voluntary Contribution (AVC) scheme, and the need to allow the purchase of additional years. The scheme could be offered as additional to the defined benefit scheme (for which pensionable pay would be limited to basic salary), or as a substitute scheme. The consultation document is interested in views on the payment of employer contributions towards any defined contribution scheme.
• New flexible retirement options. These are dependent on the implementation of proposed changes to Inland Revenue rules, which currently prohibit an employee drawing a pension whilst continuing to work for the same organisation. Under the new scheme, employees would be able to gradually manage the transition to retirement by stepping down in hours worked, and/or responsibility carried without jeopardising their accrued pension benefit. The employee could start to receive a pension based on the earlier service whilst continuing to accrue pension in the new role. The mechanisms by which this would be achieved are not spelt out. The consultation document also makes it clear that whilst pension payments should be actuarially reduced in cases where the pension is taken early, they should also be actuarially enhanced where an employee defers their pension and continues to work beyond 65.
• Alternative Ill Health Retirement arrangements. These include the introduction of a two tier arrangement whereby an enhanced pension is paid to those declared unable to undertake any work due to ill-health, where those deemed to be able to continue in an alternative role would receive an un-enhanced pension based on their accrued pension rights. These arrangements would be subject to review in light of new medical advice, or the employee taking up further employment in the future.
• Improvements to Survivor Benefits. Under proposed Government legislation, the LGPS will have to offer equivalent benefits to all married and registered civil partners. The consultation document proposes that the LGPS scheme goes further and offers (at individual employer discretion and employees cost) the equivalent benefits to all co-habiting partners, whether registered or not.
• Improvements to Death in Service benefits. These would now be paid at 3 times final salary, as opposed to the current payment of 2 times salary.
• In line with Inland Revenue changes, the removal of the earnings cap of £102,000, the removal of the 15% limit of salary that can be paid towards future pension benefits, the removal of the 40 year limit for paying into the pension scheme, and the introduction of a lifetimes pension allowance, (initially £1.5m) before pension benefits are subject to a tax charge in addition to the normal income tax levy.
• Possible regulatory powers to improve administration. The detail in this part of the consultation paper is particularly sketchy, but does include the idea of the administering authority being empowered to make differential charges to employers dependent on the timeliness and accuracy of their information returns.

8. The consultation document does cover a number of more detailed points and includes a number of specific questions of detail in addition to the main issues highlighted above. At this stage of the consultation process, it is recommended that the Committee focuses on the more strategic issues as detailed above. We can return to the more specific questions as and when the ODPM introduces greater clarity into its thinking behind the document.
9. The Government Actuary has costed the ideas contained within the consultation paper and estimated that the on-going costs of the LGPS would be in the region of 21% of pensionable pay. Whilst the ODPM appear in the paper to be pledging to restore the 60:40 ratio between employer:employee contributions, they have also set the average employee rate at 7%, indicating a 67:33 ratio. For those organisations with a staff profile with significantly higher numbers of low paid staff, (and therefore an average employee rate of lower than 7%), the ratio may be even further weighted towards the employer.

Issues for Consideration

10. This Committee needs to view the proposals in light of the overall objective of delivering an affordable and sustainable LGPS. There is already strong criticism of the fact that council tax payers are under-writing the guaranteed benefits of LGPS members. This is a criticism that the LGPS, alongside other public service pension schemes must address, if it is to be sustainable into the future. The sustainability of the scheme also requires that the proposals assist in the recruitment and retention of staff to the public services, and that these staff do join the LGPS.
11. As stated in paragraph 5 above, the ODPM views the first two phases of the stocktake, including the flexibilities provided under the Funding Strategy Statement, as sufficient tools to stabilise current funding arrangements. Early work on the 2004 valuations would suggest that this has not been the case. Whilst the stocktake proposals will help reduce on-going liabilities, the transitional arrangements mean that this help is going to be slow in arriving, at a time where increased life expectancy is leading to a rapid increase in scheme liabilities. When added to the growth in past service deficits arising from the poor investment returns seen across all pension funds over the last three years, and the impact of Government changes to the tax arrangements for pension funds, the overall effect is going to be significant increases in employers’ contribution rates for the foreseeable future.
12. The ODPM figures of the costs of the LGPS going forward, based on the work of the Government Actuary, would suggest that the consultation document is unlikely to alter substantially the costs going forward. The increase in the average employee contribution rate will largely be required to fund the higher pension accrual rate, and the improved benefits detailed above.
13. It is therefore likely that employer rates are set to be significantly higher going forward, and this will present a major problem to a number of Fund employers, especially those with fixed incomes. In responding to the consultation document, the Administering Authority and employers may therefore wish to consider alternative propositions to those included in the document.
14. Two areas which deserve further consideration are a move towards an average salary scheme, and a further increase in employee contribution rates. In respect of a move towards an average salary scheme, the argument would be that such a change would deliver reductions to the on-going scheme liabilities, whilst also addressing the issue of equity between scheme members. An average salary scheme does directly link the benefits received by a scheme member to the contributions they have made to the Fund over the course of their career. The current final salary scheme clearly favours those who progress through a series of salary increases during their working life, and in particular those who receive significant increases in salary towards the end of their careers. Whilst their pension is based on their final salary, their contributions to the Fund have been based on a much lower level. In effect, a significant number of staff, who have little salary increase (apart from the annual cost of living increase) are subsidising those who have been successful. Consideration of the average salary option will need to be in conjunction with the detail of the new flexible retirement arrangements, which allow people to step down from demanding higher paid jobs but preserve their pension entitlement. Further options may also be raised during the consultation which will deliver similar objectives to the average salary approach.
15. The move to a final salary scheme whilst leading to savings to the fund in terms of reduced liabilities, also needs to be considered in terms of impact on those staff who will receive a lower pension going forward, and whether it will have any detrimental impact on the recruitment of key staff to the public sector.
16. The issue of a further increase in employee contribution rates needs to be considered in terms of the balance of funding between employees and employers (and hence council tax payers). The consultation paper appears to be inconsistent in arguing for a return to the 60:40 ratio, whilst proposing a 7% employee rate within a 21% total cost.
17. There is an argument in terms of whether the 60:40 ratio should be limited to the future liabilities, or should reflect all liabilities associated with the Fund. Maintaining employer contribution rates in excess of 20% for the next 25 years, whilst limiting the employee contribution rate to an average 7% is going to lead to further criticisms from council tax payers, as key stakeholders, and therefore question the schemes sustainability. The current implied assumption, that employees should not contribute towards past service deficits needs to be considered against the benefits accruing to current employees, and the costs to the employers and council tax payers. As with average salaries, the impact on staff recruitment and retention of any changes in employee contribution rates does need to be considered.
18. In addition to the questions around some of the key principles, there is also a considerable amount of work to be done in understanding the practical implications of the ideas raised within the consultation paper. To a certain extent, consultation responses will need to focus on whether the ideas raised are acceptable in principle, with the proviso that they can later be rejected if the practical problems outweigh the benefits. Key issues within this will be the basis and work required in moving all active scheme members across to the new scheme, the impact on current employees and pay claims of the proposed variable employee contribution rates, the difficulties faced by employers in verifying the status of non-registered co-habitees before the payment of survivor benefits, and whether the package as a whole is likely to encourage more people into local government employment and more employees into the scheme.

Next Steps

19. As stated above, the consultation period does not end until 31 March 2005, and it is therefore proposed that a draft response to the consultation is prepared for full consideration at the February meeting of this Committee. To enable this response to be fully informed, this paper and further briefings will be sent to all employers, to enable them to formulate their own responses to the consultation. The issues will also be discussed at the Employers’ Forum on 30 November, and a further workshop can be arranged in the new year if employers so desire.
20. The ODPM are setting up a Development Group to discuss the Green Paper. Representatives have been invited from the following groups:

• The Local Government Association (LGA)
• The Employers Organisation (EO)
• The Trades Union Council (TUC)
• Society of Chief Personnel Officers (SOCPO)
• Association of Consulting Actuaries (ACA)
• Local Authority Treasurers, England and Wales
• Pension Practitioners, England and Wales

21. The ODPM intends to report on this consultation exercise to Ministers in the early part of the summer of 2005, with the view to publishing specific proposals later in 2005. Draft regulations would then be circulated for consultation in 2006, with the intention of having the new regulations in place for April 2007, and coming into force in April 2008, alongside the results of the 2007 valuations.
22. As covered above therefore, responses to the current consultation therefore need to focus on the principles contained within the paper, with some recognition of potential practical difficulties. A more considered response can be developed during 2005 and 2006 as the ODPM develops clearer proposals, and the detailed arrangements for the implementation of any changes.

RECOMMENDATION

23. The Committee is RECOMMENDED to note the content of this report, to endorse it as the basis of approach to all Fund employers to stimulate discussion and debate on the consultation document (with any further information that they would wish to see presented), and to endorse the next steps set out in paragraphs 19-22 above.

SUE SCANE
Head of Finance & Procurement

Background Papers: Facing the Future – Propositions and Principles for an Affordable and Sustainable Local Government Pension Scheme. The consultation Letter published by the ODPM, 4 October 2004.

Contact Officer: Sean Collins, Assistant Head of Finance, (01865) 815411

November 2004

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