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Public sector pensions, employer contributions and the cost cap

Cutbacks iStock 000013353612XSmall 146x219The Treasury has announced higher employer contributions towards public sector pensions from 2015. Neil Bhan considers the move and looks at the details of the employer cost cap.

The Government has confirmed that higher employer pension contributions to public sector pension schemes will come into force in 2015. It has also set out more details of the "employer cost cap", a mechanism to effectively share the risk of increased public sector pension costs between employers and scheme members.

Increase in employer contributions

The Government has confirmed that current pension contribution rates to the public sector pension schemes are insufficient to meet the future costs of the schemes, including the NHS Pension Scheme, the Local Government Pension Scheme and the Teachers' Pension Scheme. The results of scheme valuations will be published over the coming months and changes to employer contribution rates will come into force in 2015 - ie employers (e.g. in government departments, education and health sectors) will need to increase their contributions in line with the results of the new valuations.

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The employer cost cap - introduction

An employer cost cap is being introduced to cover unforeseen events and trends that significantly increase public sector pension scheme costs. The cap is intended to provide backstop protection to the taxpayer, with changes which need to be made to contribution rates due to ‘member costs’ being controlled by the cap, and financial cost pressures being met by employers:

  • The cost cap will include the impact of changes in costs such as actual or assumed longevity, of careers or the age and gender mix of the workforce. These costs cover the main public sector schemes (old and new) and all types of service (past and future) of active, deferred and pensioner members.
  • Changes in actual and assumed price inflation and what is termed the "discount rate" will be excluded from the cost cap. The discount rate is the assumed future investment return used in a present value calculation of assets.

Public sector pension scheme valuations will take place periodically to assess how the cost of providing the pension scheme has increased or reduced. In the event that member costs drive the cost of the scheme above the cap or below the floor, there will be a period of consultation with relevant groups, before changes are made to bring costs within the cap and floor. If agreement cannot be reached through consultation, the accrual rate will be adjusted as an automatic default. The employer cost cap will be set at 2% above the employer contribution rates calculated following a full actuarial valuation ahead of the introduction of the new schemes in 2015.

Setting the level of the cap

Preliminary valuations of the public sector schemes, valued “as at” 31 March 2012, will form the basis for the new cost control framework and will be used to set the cost cap. The preliminary valuations are being conducted on the assumption that the schemes will be reformed in line with agreed proposals from 2015 (2014 for LGPS in England and Wales). The level at which that cap will be set will be based on an assessment of the future service costs of the new schemes – the costs of the benefits being accrued by current members. It will not take into account any past service costs that have arisen in the existing schemes due to previous over- or under-estimation of costs before those schemes closed. This means that when the level of the cap is set, it is likely to be different from the employer contribution rate actually paid. This is because the rate paid from 2015 will also reflect past service costs associated with members of the pre-2015 schemes.

The preliminary valuation of the new schemes will calculate a cost cap based on the costs of providing the new scheme benefits from 2015-19, generally using assumptions relevant to that period.

Costs that will be controlled by the cap

The employer contribution rates calculated by the valuations will continue to reflect all future and past service costs associated with the schemes (and connected schemes). However, the cap mechanism has been designed so that some of these elements are excluded from it. As only active members will see their future benefits or contributions adjusted if the ceiling is breached, the Government considered that it would be unfair to control all of the costs associated with pensioner and deferred members of the existing pension schemes. These elements of costs will therefore not be controlled by the cost cap mechanism.

The cost cap will control all other member cost risks, including the past and future cost risks associated with active members of the reformed schemes, including any service they have in the existing schemes; and deferred and pensioner members of the reformed schemes; and "transitionally protected" active members of the existing schemes. Public service employers, and ultimately taxpayers, will bear the additional risk associated with pensioner and deferred members of the existing schemes, rather than the members themselves.

Operation of the cap

There may be fluctuations in scheme costs between valuations. So that these do not lead to frequent changes in the scheme design after each valuation, Treasury regulations specify that there will be a 2 percentage point margin above the cap - the upper margin will form a “ceiling” on the employer contribution rate. For example, if the employer cost cap is set at 18% of pensionable pay, the ceiling will be set at 20%.

Costs may be rebalanced by amending scheme benefits for future accruals to alter the overall cost of the scheme, or by altering the level of employee contributions so that a higher or lower level of employer contributions is required. Scheme regulations will set out a process for agreeing the necessary action with stakeholders, and default action to be taken if agreement cannot be reached within a reasonable time limit.

“Employer costs” and “member costs”

Many of the assumptions that must be made to carry out a scheme valuation relate to the profile of scheme members – for example the expectations about their life expectancy, growth in salaries, or career paths. For the purpose of the operation of the cost cap, these will be defined as “member costs”. Other decisions and assumptions that must be made to carry out a valuation are financial or technical in nature, and will be defined as “employer costs”.

The Government has stated that the cost cap mechanism will only capture changes in costs arising from changes in the “member costs”. Changes in costs that arise solely from changes in “employer costs” will not be captured by the employer cost cap and so will not trigger changes in member contributions or future benefit accruals ie public service employers, and ultimately the Exchequer, will bear the risks of changes in “employer costs”.

For the purpose of the cost cap mechanism, the changes in costs arising from the following will be regarded as “employer costs”, and will not affect the cost cap mechanism:

  • the discount rate used for measuring costs in the unfunded schemes. This is currently set at 3% per annum + CPI, and is subject to a regular review process.
  • the long-term earnings assumption.
  • the actuarial methodology used for calculating scheme costs.
  • the price inflation assumptions (based on CPI). All of the valuation costs are measured in CPI-real terms, and therefore changes to CPI will not affect the employer cost cap mechanism.

Future reviews of the cap

The Government will set the cap to take account of expected changes in future scheme costs. However, there may be future changes in scheme costs which the Government may not wish to affect members via the cost cap mechanism, even though they are unexpected. Eg improvements in scheme data may lead to changes in the costs of the schemes as measured by the valuations. Similarly, there may be one-off shifts in the costs of the schemes.

There may also be some potential changes in scheme costs which cannot be easily quantified at the preliminary valuation. For example, increases in the State Pension age may lead to an increase in the average age of the public service workforces. All things being equal, this would lead to a rise in scheme costs. However, there is no way of accurately forecasting the potential impact of such changes at this stage.

Any decisions about whether such changes should feed through to the employer cost cap mechanism, and therefore to scheme members, will be taken on a case-by-case basis. balancing the interests of scheme members against the need to protect the taxpayer and ensure that the costs to employers remain sustainable. If any adjustments are made, these may be via an adjustment to the level of the cap, to the valuation process, or by some other means. It is anticipated that such reviews will take place before each round of scheme valuations (the Government will discuss any potential changes with stakeholders).

Neil Bhan is a Partner at DAC Beachcroft. He can be contacted on 020 7894 6512 or This email address is being protected from spambots. You need JavaScript enabled to view it.

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