Pensions analyst Michael Johnson on the failure of governance in the local government pension scheme – and how reform can save the taxpayer nearly £1 billion a year
The Local Government Pension Scheme (LGPS) is in crisis, argues Michael Johnson in The Local Government Pension Scheme: opportunity knocks, published on Monday 25 November by the Centre for Policy Studies.
The LGPS matters: it is by far the largest funded pension scheme in the country, with total assets in excess of £200 billion, some 5.2 million members (active, deferred and pensioners) and more than 7,000 participating employers.
It comprises a disparate collection of 101 opaque, predominately sub-scale, inefficient, funds, with excessive costs and lax governance. All 101 funds are underfunded: the average funding ratio for the 89 English and Welsh funds was 77% on the last reported valuation date (31 March 2010), and 94% for the 11 Scottish funds (31 March 2011). Some funds are now so under-funded that they are consuming their assets to meet pensions in payment: they are beyond the point of no return, in a death spiral, heading to an unfunded status.
Johnson condemns the LGPS as "woefully inefficient". The paper includes a cost comparison of the LGPS funds, which shows a strong negative correlation between administration costs per fund member and fund scale: the larger the fund, the lower its costs. Fund administration costs per member range from £13.70 a year (Nottinghamshire) to £139.40 a year (Durham). The range of investment management costs is even wider, from £7.60 per member (West Yorkshire) to £317.30 (City of London). Using evidence drawn from some of the world's most efficient public pension funds, and allied databases, Johnson estimates that a restructured LGPS should be able to cut costs by at least £860 million per year.
Johnson makes ten simple proposals which would cut costs, by harnessing economies of scale. "Costs are controllable, whereas investment performance, by and large, is not. This necessitates structural change and could help secure the future viability of the LGPS."
His proposals are based on three simple steps:
• Improving transparency, and adopting widespread standardisation, essential prerequisites for the digitisation required to centralise all LGPS administration. Such an initiative would require a huge cultural change within DCLG and the LGPS, but silos have to be broken: the cloud has transformed everything. We can no longer simply design for today's cultural norms. The LGPS's expensive, paper-based, administration is in need of transformation.
• Redesigning the investment process, emphasising investment in passive, not actively managed, funds. Today's reliance on external management to invest £9 billion in private equity, for example, is an extraordinary exhibition of profligacy and missed opportunity.
• Facilitating fund mergers, preferably using a dramatically improved governance framework. This could require each LGPS fund to conduct annual tests to evidence that their members are not disadvantaged by a lack of scale in assets or membership. Funds that fail such tests would be required to merge, which would best serve members' interests.
"Ministers are aware of the need to restructure the LGPS, and are taking steps to set this in motion. Support for such an initiative would come from across the political spectrum, as well as from many within the public sector unions: they understand that fund mergers would best serve the interests of their membership. Reduced costs (akin to improved fund performance) could be used to slowly restore funds' financial health, as well as potentially leaving some scope for sharing the benefits between members and employers through, for example, lower contributions."
Tim Knox, Director of the Centre for Policy Studies, comments:
"Badly managed LGPS funds are bad for both local government employees and for taxpayers. Grouping small funds together, while preserving competition, will achieve both substantial savings for the taxpayer and better pensions for council employees."