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A gorilla in the garden

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If you opened your curtains one morning and saw a gorilla in your garden, what would you do? Close the curtains and check again in three years’ time?

Probably not. But while local authority pension schemes have the potential, if left unchecked, to create huge damage to local councils, few are actively taking measures to address the issue.

The facts are stark. Public sector pensions have an estimated £1tn deficit. This is equivalent to the total of all the defined benefit schemes in the private sector combined - but the private sector’s have been subject to much more accountability, scrutiny and regulation and have been forced to address the fundamental issues that underlie these promises.

There might be good reasons why managers do not address their pension schemes as fully and frequently as they would like. There are governance and strategy issues all the way up to the council chamber, as well as the pressing day-to-day concerns of how to

chart a course through these uniquely challenging times.

It is also the case that existing defined benefit pension schemes might appear relatively healthy because the local authority workforce has expanded massively in the past few years, reducing demands on current cash flows.

But there is an urgent need to take early action to reduce some of the longer-term risks. Historically, market movements have been actuarially smoothed to ensure that contribution rates have been not too volatile. But over the next few years, this smoothing will be more difficult, given the severity of recent market movements and the changes required to reflect the fact that people are living longer.

The good news is that if early action is taken, the situation could be quickly brought under control. The reason is simple. Although the range of options available to private sector employees will also be available to the public sector, local authority pension schemes have one huge advantage over private sector-defined benefit schemes - the employer covenant.

Although this has been seen as a criticism of these schemes, the fact that a local pension scheme is underwritten by the government should allow it to invest more of its assets in higher-returning, more volatile assets, and remain protected from short-term volatility in the market. This should enable the benefit of equity returns over the longer period to fund the promises - not local taxpayers.

Indeed, there is no reason why local government should not follow the example of the large North American quasi-government schemes such as the California Public Employees’ Retirement System and the Ontario Teachers’ Pension Plan, which are leading the way in innovative investment thinking, for example through private equity investment and private placements.

The key is to integrate the employer covenant fully into the pension scheme risk analysis, alongside the considerations of liabilities, assets and governance. It is imperative that the interaction between these four risks work efficiently and effectively.

This complex interaction between what has been promised, what has been contributed so far, how much is going to be paid in the future and how the scheme is managed is more relevant than the public sector has traditionally assumed.

So what can be done?

  • First, it is imperative to understand the need to take early action.
  • Second, it is important to identify, understand and calibrate the risks and cash flows, and monitor them.
  • Third, a strategy needs to be developed and executed, building on private sector experience of dealing with defined benefit pension issues.

The longer you leave that gorilla in your garden, the bigger and hungrier it may get. Feed it, communicate with it or reach for your tranquiliser gun, but don’t, whatever you do, ignore it.
Richard Farr, partner, BDO

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