UK - Local government pension schemes in the UK could see negative cash flow on the back of opt-outs if 40% or more of scheme members halt pension contributions, the country’s largest public sector union has warned.

Citing a report by First Actuarial that used the London council of Barnet’s local government pension scheme (LGPS) as an example, Unison warned that lower contributions and fewer active members would also result in higher deficit contribution payments for the council.

The £627m (€715m) fund currently faces a deficit of £190m, according to the most recent actuarial valuation, but opt-outs could increase as a result of proposed reforms that will see public sector workers pay as much as 3.2% higher contributions at a time of high inflation and wage freezes.

First actuarial calculated that Barnet’s cash flow in 2010 of £23m could plummet to a loss of £25m a year if as many as 80% of members were to cease contributions. However, negative cash flow would result from an opt-out rate of 40% onward.

It also warned that the reduction in active members would result in a greater number of maturing and pension-age members, with First Actuarial estimating Barnet would be forced to shift its investment strategy away from a “predominately” equity-based portfolio to a higher exposure to gilts and corporate bonds.

“This, together with a greater proportion of liquid assets (such as cash) being held due to negative cash flow, could lead to a reduction in the return achieved on the fund’s assets in the future,” the consultancy said.

Asked if the 70% equity allocation used by Barnet was unusual, Hymans Robertson’s Linda Selman said it was “quite close” to the average level for LGPS.

The head of LGPS investments at the consultancy argued that while the private sector in the UK had changed its asset allocation in the past decade, public sector schemes did not need to shift away from these growth assets as they enjoyed a longer investment horizon compared with private defined benefit schemes that are beginning to mature.

Selman also said local government schemes enjoyed the benefit of a stronger covenant, but was quick to dismiss the notion they had not seen changes in their strategic asset allocation.

“While it might look like the LGPS hasn’t done very much, if you scratch below the surface, you find there are actually some quite significant changes,” she said.

“What we have seen within the equity portfolios is a lot more diversification, allowing for a more international focus.”

The First Actuarial report, commissioned by Unison, warned that a shift in investment strategy away from risk assets would impact funding levels in other ways than simply reducing returns.

It said the reduced discount rate assumption resulting from this shift could result in Barnet’s funding ratio worsening by 2016, despite deficit reduction payments of £15m a year.

The consultancy suggested that enhanced transfer value (ETV) exercises could be used to reduce liabilities, but admitted it could not predict if this would decrease liabilities or not, as the outcome depended on the agreement.

Despite First Actuarial calculating the impact of between 10% and 80% of members opting out of the scheme, Selman argued that the outcome was still unknown.

Peter Wallach, manager of the Merseyside Pension Fund, said in the current issue of IPE: “Since the publication of the Hutton Report [in March], the number of phone calls from active members wishing to leave our scheme has risen by 48%.”

However, Selman was less sure. Referencing both government and union estimates, she said: “You have the two extremes there, between the 1% and the 50%, but there could be quite a big range between funds.”

However, she admitted that, if the maturing profile of LGPS were to change, it would lead to further diversification.

“The absolute return fund is something a lot of them are looking at,” she said, having previously noted a growing interest from the schemes in real assets, such as infrastructure.

“Also, if we see increasing maturity and at the same time funding levels improving, then we have a real opportunity to take some risk off the table,” she said.

Topics