Treasury urged to adopt new public service pensions discount rate

HM Treasury has been urged to consider a new way of flexing the rate of public service pension increases to reflect economic growth, following its consultation on proposed changes to the public service cost control mechanism and discount rate methodology.

The consultation sought views on the methodology used to set the Scape discount rate, which is used in the valuation of unfunded public service pension schemes to set employer contribution rates and has been in place since 2011.

In response, the Association of Consulting Actuaries (ACA) warned that whatever method is used, the resulting assumptions will "almost inevitably either over-estimate or under-estimate the true cost of paying these pensions for future generations of taxpayers".

"The underlying reason is that the pensions are linked with inflation and not to future economic growth, which is the driving force of our economy’s ability to pay these pensions," ACA pensions in public services committee chair, Bart Huby, explained.

Given this, the ACA outlined a “fairer way” of dealing with the issue by changing the way unfunded public service pensions are increased from inflation to economic growth, which would meet the key objectives of the exercise, in particular inter-generational fairness and risk control.

In addition to this, Huby explained that if the economy grows faster than anticipated, the pensions for public servants would increase faster than inflation, whilst if the economy grows slower than expected then pension increases would be lower than inflation.

He continued: “Importantly, public servants would still receive a defined benefit pension based on their service and earnings, something which is now very rare in the private sector.

"Changing the way their pensions increase to be linked to economic growth would make the cost of these pensions more sustainable. Tackling the underlying pensions would be more effective than looking to the technical model used to set discount rates."

ACA has also responded to a second HMT consultation, which sought views on proposed changes to the cost control mechanism, suggesting that any changes made to the Scape methodology are also reflected in the proposed economic check “as it is so key to the level of employer contributions paid in the unfunded pension schemes”.

The consultation on the cost control mechanism was launched following a report from the Government Actuary's Department (Gad), which concluded that the mechanism needs to take into account more of the factors affecting the cost of providing a pension to protect taxpayers.

In light of concerns highlighted, the government was seeking views on three proposed changes to the mechanism, all of which were recommended by Gad's report and aim to help establish a fairer balance of risk between taxpayers and scheme members.

In its response, the ACA agreed that the government should bear the full risk on legacy schemes and not seek to share those risks with the future workforce.

However, it said that the case has not been sufficiently made for the choice of a reformed scheme design over a future service only decision, and that the consultation had not considered if the assumptions adopted for the baseline costing for the cost
management process were or are appropriate.

"With the benefit of hindsight and the opportunity to review the cost sharing mechanism at this time, given developments in longevity and cost constraints impacting public service pay awards, we believe an opportunity is being missed to review those assumptions and reaffirm that they are best estimate," its response said.

Furthermore, responding to proposals to widen the corridor, whilst ACA agreed that stability was desirable, it warned that this could result in a step change to benefits when the corridor is breached, stating that there should be a balance between stability of the
frequency of change of benefits and the stability of the level of benefits.

Hymans Robertson, however, welcomed the proposed changes to the mechanism and the stability they could bring to future cost cap valuation results, with head of LGPS valuations, Robert Bilton, stating that the ‘economic check’ in particular will help to reduce the potential for ‘perverse’ results to occur.

“The check should make it less likely that we will see a recurrence of the situation where benefit improvements are proposed at the same time as contribution rate increases from the 2016 actuarial valuations,” he stated.

“To achieve an even stronger result we believe the government could go one stage further and introduce a qualitative review of the raw results from the mechanism.

"This would provide a ‘common sense’ check on what is otherwise a very objective and formulaic process. The governance arrangements and stakeholders involved in such a review would need careful thought.”

Bilton also agreed that the Scape discount rate should not be used for Local Government Pension Scheme (LGPS) funds, explaining that whilst basing the Scape rate on UK GDP may be a good measure for unfunded public service schemes, the funded LGPS has a "significant level of investment in overseas markets, and across a broad range of asset classes".

“We would prefer that the LGPS cost control mechanism uses a discount rate which reflects the expected return from the overall asset allocation of LGPS funds,” he concluded.

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