Gad outlines cost control mechanism reform recommendations

The government’s current cost control mechanism in public service pension schemes is not able to protect taxpayers unless it takes into account more of the factors affecting the actual cost of providing a pension, according to the Government Actuary’s Department (Gad).

The comments were made in light of analysis of the preliminary results of the 2016 valuations, which showed a breach in all schemes for which results were assessed.

The report stated that the mechanism had performed in line with how it was constructed, with lower pay increases and reduced life expectancy assumptions suppressing the member element of the costs, leading to breaches of the cost cap floor.

However, when considering this outcome against the objectives of the cost control mechanism, the context of the recent reforms and the wider economic environment, it acknowledged that this could be considered "to be a somewhat perverse outcome".

In particular, the report pointed out that 60 per cent of the cost reduction leading to the breach arose in legacy schemes, yet the cost control mechanism can only amend benefits in the reformed schemes.

"Whilst one might ordinarily expect a degree of solidarity across generations, the cost reductions in past service benefits arise disproportionately in respect of older and longer serving members whilst the implementation of any future benefit improvements would benefit disproportionately the younger and newer members," it stated.

"This disproportionality in the application of benefit change would seem to be tending towards intergenerational unfairness."

In addition to this, it noted that these costs relate to risks that have largely been mitigated in the reformed schemes, arguing that "it is not clear" why these residual risks in the legacy schemes should continue to influence the level of benefits in the reformed schemes.

Considering this, the report concluded that, in the circumstances, it might be considered generous for members to be immunised against all the long-term financial downside risks whilst being able to benefit from the upside of other risks.

It also noted that whilst comparison with private sector pension schemes is not an objective of the cost control mechanism, many employer sponsors of such schemes faced with similarly rising costs have felt the need to limit the value of the schemes to members.

Whilst there are alternatives systems, it emphasised that a mechanism is preferable, stating that, in principle, the concept of a risk sharing arrangement such as the cost control mechanism is a good one, as it can set out how pension scheme risks are to be managed and therefore provide a greater degree of security and certainty around costs.

However, it warned that difficulties can arise in the precise choice of components of the mechanism, stating that the balance of these elements can lead to consequences that might be considered unintended or inequitable.

In light of these concerns, the report outlined a two-stage framework, which incorporated a number of proposed changes to the core mechanism and elements of validation that could be introduced to moderate the effects of the core mechanism.

The recommendations included a reformed scheme only, which would remove any allowance for legacy schemes, and a future service only option, which would only consider the costs of future service accrual in the reformed schemes.

In addition to this, it also outlined proposals for a ‘widened’ corridor from the current +/-2 per cent of pensionable pay to +/-3 per cent to reduce the volatility of the mechanism, suggesting that it would also be reasonable to consider wider corridors for schemes with a higher cost.

Further proposals included recommendations for an additional layer of qualitative review, which would allow for reasoned judgement to be used to determine whether or not to apply the results of the cost cap valuation, as well as an affordability check.

Concerns around the Gad’s findings were also highlighted by the House of Commons Public Accounts Committee report, published earlier this month.

In a parliamentary written statement, Chief Secretary to the Treasury, Steve Barclay, stated: "The government is committed to providing public service pensions that are fair for public sector workers and for taxpayers. The cost control mechanism was introduced into the valuation process for public service pension schemes in the Public Service Pensions Act 2013 following consultation with member representatives.

It was designed to ensure a fair balance of risk with regard to the cost of providing defined benefit (DB) public service pension schemes between members of those schemes and the taxpayer.

"I commissioned the Government Actuary to conduct a review of the mechanism amidst concerns that it was not operating in line with its original objectives.

"The Government Actuary’s report sets out his findings and makes a number of recommendations on possible changes to the mechanism. The government will respond to this report in due course."

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