Local government pension schemes are under pressure to deliver sustainable reforms. Can they support the nation’s demand for infrastructure development as well, asks Bob Campion

Local government pension schemes (LGPS) have endured a period of unprecedented political and public scrutiny, yet so far they have emerged with their dignity intact. Along with other public sector pension schemes, the LGPS have spent the last two years as the subject of a formal review instigated by a coalition government strapped for cash and under pressure to cut spending. The changes recommended by Lord Hutton and subsequently put forward by the government have been designed to make the LGPS fairer and more sustainable, without losing its defined benefit structure. But as the pensions industry awaits the finer details of the new-look LGPS ahead of implementation in 2014, the government has revealed it has other plans for the LGPS – as a source of much-needed funding to develop the nation’s infrastructure. At the same time, experts are warning that the public sector pension shortfall could reach unmanageable levels before the end of the decade, requiring much more radical reform. So is the LGPS safe after all?

Public sector pensions have been under the microscope since the early days of the coalition government when Lord Hutton was invited to review their affordability. It was the unfunded or pay as you go pensions of teachers, NHS staff, civil servants, armed forces and police – to name a few beneficiaries – that were the chief targets as they cover roughly 85 per cent of public sector employees. But the substantial changes to all public sector pensions laid out in the Public Service Pension Bill, which is enjoying its second reading in the House of Commons, will affect the LGPS equally. Career average will replace final salary as the basic defined benefit structure for new accrual, with pensionable age linked to the rising state pensions age. To sweeten the pill, it is proposed that members within 10 years of retirement will be unaffected. But on the other hand, a ‘cost management’ clause is included, allowing for benefits to be cut or contributions raised if costs rise substantially more than is envisaged.

Overall, LGPS members have concluded the reforms to be fair, with 95 per cent of the members of public sector union GMB backing the reforms in August. But the battle is far from over. The GMB warned in October that important details of how the LGPS reforms would be implemented were overdue and that the Public Service Pension Bill was in danger of tarring the funded LGPS with the costly brush of the unfunded pensions. A paper released by the Centre for Policy Studies in November had the potential to obfuscate further. The report led with the headline statistic that “nearly £4 in every £5 paid in pensions to public sector workers will come from the taxpayer” and went on to predict that the shortfall between contributions and pensions in payment would soon reach unsustainable levels, reaching £32 billion a year by 2016-17. It added that the current reforms would take between 20 and 30 years to generate savings in light of the 10-year moratorium for those soon to retire.

These scary figures, and many variants on them, were seized upon by the national press, which concluded that the problem of public sector pensions was far from solved. And yet, the CPS study, as so much of the research on this subject, considered only the unfunded public pensions, not the LGPS. While the £148 billion LGPS, made up of 101 separate schemes, was recorded as £54 billion in deficit on aggregate at the last actuarial valuations in 2010/11, this was based on bond discount rates significantly lowered by quantitative easing. As with all funded pension schemes, estimated liabilities are widely considered to be exaggerated under the current economic conditions. But whatever their true cost, the burden of the LGPS on the tax payer is nowhere near that of the potential £32 billion annual cost of the unfunded pensions, particularly if the 2014 reforms achieve their stated aim of saving £900 million. Indeed, Treasury Chief Secretary Danny Alexander is so confident the LGPS reforms are sustainable that he pledged they would remain in place for the next 25 years. “As far as the government is concerned negotiations have concluded,” says Hymans Robertson head of public sector John Wright. “We don’t expect any change of course on any significant element of the reforms. Details specific to the LGPS have still to be agreed and will be in secondary legislation.”

While some still fear that the chief threat to the LGPS is that the schemes might get drawn into tougher reforms in the near, if not immediate, future, its £148 billion of genuine assets has not gone unnoticed by the government. In November a consultation was launched proposing to relax the restrictions currently in place on LGPS investments in infrastructure, with the specific objective aired by communities secretary Eric Pickles of injecting £22 billion into transport, housing and regeneration projects. The consultation makes it clear that it is up to the LGPS to determine their own investment strategy, but by raising the 15 per cent upper limit on investments in the limited liability partnerships favoured by infrastructure funds, the intention is clearly there to unlock a significant bank of capital.

That puts the councillors who largely decide on LGPS investments in a tricky position. LGPS have to date preferred more tried and tested investment routes such as bonds, property and equities. Infrastructure investments of the type envisaged by Pickles are far more complex. While infrastructure has the potential to be a good and stable partner for pension schemes, offering inflation-linked low risk long-term returns for a decent yield above gilts, it is also illiquid and can be high risk. “Projects like this are very long term and carry an enormous amount of risk,” says Dickinson Dees head of the public sector and voluntary unit in the pension team Tracy Walsh. “There is also the potential for high returns, but many local authorities are not actively planning on changing their investment strategy. There will not necessarily be a change across the board just because the option has been put on the table.”

Early stage infrastructure projects that require substantial planning and construction run the risk of being delayed, running over budget and saddling investors with substantial losses. Memories of relatively recent construction projects such as the Millennium Dome (£200 million over budget) will weigh on the minds of councillors. So too, though, will the thought of fostering economic growth in their region, a policy likely to be popular with the voters responsible for electing them. With a well developed £40 billion pipeline of government infrastructure projects already in place until 2014/15, LGPS committees will find themselves under pressure to back initiatives receiving public support. But they could also saddle their members with significant risk. A bad investment that leaves the LGPS worse off could make it more likely that future benefits would be cut back even further or council taxes increased, both of which would hit members directly in the pocket.

“The concern is that people have oversimplified infrastructure investing,” says Russell Investments director, consulting services, Nick Spencer. “It is not a risk-free way of generating returns.” Even investments which work out profitable in the end would lock up significant cash reserves for many years and depress valuations in future actuarial assessments. A project led by the NAPF and PPF to deliver an infrastructure platform in 2013 to facilitate investment by pension schemes may well address some of these practical concerns, though the details are not yet clear. But at a time when LGPS are under pressure to improve their governance standards, adopting private sector pension-style practices under the ‘Fair Deal’ proposal, which could see private sector contractors joining the schemes, councillors will be particularly wary of using members’ money to engage in social or political projects.

The LGPS now have a sound platform to build on in future, but they cannot rest on their laurels. They remain underfunded and will soon be the last bastion of defined benefit schemes open to new members. The perils of running DB schemes are well known, and the current reform programme though sustainable as it stands does not deliver massive cost savings. The LGPS could still run aground if investments turn sour or costs rise, such as through higher than anticipated increases in life expectancy or inflation. For these reasons, councillors should treat with caution requests for social investing, no matter how well intentioned. As with all DB schemes, it is the members who stand to lose out if funding falls. The government has clearly signalled that future increases in cost will have to be shared by its members, and it is up to their guardians to ensure that that does not become necessary.

Written by Bob Campion, a freelance journalist

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