14 Sep 2018

On 6 September 2018, Elizabeth Truss (Chief Secretary to the Treasury) released a statement providing an update on the 2016 valuation process for public sector pension schemes that are unfunded, such as the Teachers' Pension Scheme, the NHS Pension Scheme and the Civil Service Pension Scheme. 

Initial indications from the ongoing valuation process indicate that:

  • the costs for a number of schemes have reduced to such a level that either active member benefits will be improved, or their member contribution rates will reduce, but 
  • employer contributions will rise.

This does not impact the Local Government Pension Scheme, however, which is a funded scheme and has its own triennial valuation regime.

Actuarial valuation framework

The new framework for actuarial valuations was established as part of the public sector pension scheme reforms in 2015. Given that the majority of employers in these arrangements are public sector bodies which are funded at least in part by tax revenue raised by central Government, the purpose of these reforms was to rebalance the cost risks of the unfunded public sector schemes between the members and the taxpayer. Ultimately however, HM Treasury pays the balance of costs for these schemes, where there are insufficient scheme assets to meet the long-term liabilities.

To achieve a balance of risk and long-term sustainability, an employer cost cap mechanism was established. The idea was to protect taxpayers and scheme members from unexpected pension cost changes. Only those changes that relate to members (such as life expectancy and salary growth) are included within the cap mechanism; any changes as a result of financial or technical changes are not included.

Under the cost cap mechanism, there is a backstop employer contribution rate which is the maximum amount which the employer contributes. There is some wriggle room in relation to the cap (2% up – the ceiling – or down – the floor) but if the costs are higher or lower than that some action must be taken to remedy the situation. 

2016 actuarial valuation process

Early indications in the 2016 valuation process show that costs have fallen below the cost cap floor, in at least some of the schemes. The Government Actuary's Department (GAD) is expecting to issue the scheme valuation reports later this year and these will confirm whether such a breach has occurred. 

What will it mean if there is a cost cap floor breach? 

The Secretary of State responsible for each scheme will need to engage in discussions with the Scheme Advisory Board (introduced by the Public Service Pensions Act 2013) to try to reach an agreement in relation to the actions they will need to take to return the costs to the level of the cap in place. Unfortunately, the cost cap floor being breached does not mean that employer contributions will come down.

What are the consequences of this? 

There are a number of ways in which costs can be returned to the required level, including improving member future service benefits and lowering member contributions. Where no agreement can be reached, the legislation generally requires that the benefit accrual rate will be increased. 

Review of the cost cap mechanism

During the implementation of the cost cap mechanism, it was acknowledged by the Treasury that this would need to be kept under review. It was the Treasury's opinion that the cost cap would not be triggered for any scheme, however in the event it was triggered, it was anticipated that this would only be in exceptional circumstances. However, that opinion seems to have been wrong, with hindsight, and so now GAD will be undertaking a review of the mechanism. It is anticipated that this review will conclude in time for the next round of quadrennial valuations, in 2020. In the meantime, the outcome of the 2016 valuations will be implemented for each scheme and where the cost cap is breached, steps will be taken to return costs to agreed target levels from 1 April 2019.

Changes to the discount rate

However, in bad news for employers, the Treasury is proposing that the discount rate (used to assess the current cost of future payments from the schemes) is reduced from 2.8% to 2.4% to "reflect the Office for Budget Responsibility's long-term growth forecasts". This will mean further increases to employer contributions.