By Barry McKay, Partner and Fund Actuary at Barnett Waddingham
How have things evolved since 2022?
Of course, the funding level is just an estimate at a point in time and is constantly changing. Employers are more concerned with affordability and the stability of their contributions which, although variable, are at least fixed for three years (notwithstanding possible contribution reviews).
Asset performance: a mixed bag
There has been a range of asset returns across funds since the last valuation. Some funds have performed broadly in line with expectations (i.e. in line with the discount rate), some are slightly ahead, and some are slightly behind. Funds will also have different cash flows profiles which will impact on asset levels. Asset performance has improved recently, but as at March 2024 there wasn’t a significant improvement in funding level due to asset returns for a typical fund. So, for the purposes of this blog and simplicity, the asset returns on average may be broadly in line with expectations.
Inflation and pension increases causes liability surge
One factor that has impacted all funds, since the 2022 valuation, has been high Consumer Price Index (CPI) inflation and the pension increases awarded in April 2023 and April 2024. CPI pension increases of course apply to pensions in payment, deferred revaluation and Career Average Revalued Earnings (CARE) benefits accrued by active members. These increases were 10.1% and 6.7% at April 2023 and April 2024 respectively. Allowing for the pre-2014 final salary element of accrued benefits, this has increased liabilities by around 15%.
Unlike asset returns (assets may go down as well as up), however these are guaranteed, actual increases that are now baked into the liabilities forever more. Setting aside possible changes in assumptions and focussing on actual events, a fund that was fully funded at March 2022 might, under similar conditions, have a funding level closer to 85% at March 2024.
What about future changes in assumptions?
CPI inflation: short-term spike to long-term adjustment
During the 2022 valuation, we knew that CPI inflation was going to be very high in the short-term. The April 2023 increase of 10.1% was known and it was expected that it would remain high for at least another year or more. We therefore made an allowance for this when we set our long-term CPI pension increase assumption. The expectation for long-term CPI based on inflationary yield curves was circa 2.5% per annum (p.a.). Incorporating short-term high inflation into the long-term assumption (over 20 years) resulted in a single-equivalent CPI assumption of around 3% p.a. at the 2022 valuation.
As stated above, the pension increases awarded are now baked into the liabilities and expectations of future inflation has since fallen. Current long-term expectations, based on appropriate gilt yields, is around 2.5% p.a. – approximately 0.5% lower than assumed at 2022. Allowing for this lower future CPI, relative to that assumed at March 2022, reduces the liabilities for a typical fund by around 10%.
Hopefully, there’s nothing too controversial in what has been discussed so far – albeit there may be some debate around future inflation. It would therefore seem reasonable that the funding level at March 2024 was broadly where it was in 2022 for a typical fund.
Where’s the surplus?
Navigating uncertainty and differing views on the discount rate
To recap, the discount rate is the prudent estimate of the expected return on the fund’s assets over the long-term. The discount takes advance credit for future expected returns, and is used to estimate the amount of money you need today to meet all the members’ benefits arising each year in the future. It’s like compound interest in reverse, which Einstein described as the 8th wonder of the world. Given the volatility and uncertainty in the markets, and the number of factors that can influence future returns, this is often where views differ. Different models are used by actuaries (and therefore funds) to estimate future returns and levels of prudence to be built into the discount rate.
There are only three options when considering the discount rate – either you think future returns and risks have improved, worsened or stayed much the same when compared to the economic, political and demographic environment in 2022. If you think we are in a better place now, then you might expect your discount rate to increase as you will expect higher asset returns in the future and vice versa. And this is where the surplus – or lack of it - comes from. The increase in the assumed future discount rate is likely the only factor driving these reported improved funding and large surplus positions. Do we think the economic, political and demographic environments have improved so significantly since 2022?
The outlook for 2025
The LGPS is in a better place than it has been for a long time, although we need to be careful not to overstate this - the outlook for 2025 will be very dependent on views of future market conditions and expected future asset returns. Although our view on future returns is not significantly different from 2022, there is scope for some good news at the 2025 valuation. All assumptions will of course be reviewed as part of the 2025 valuation.
Of course, a lot could happen between now and March 2025 - recent market volatility, geopolitical issues in the Middle East, concerns about a US recession and the resulting fall out for markets is certainly a risk. It’s important not to focus too much on the funding level. This is an important metric but is only an estimate of the funding position at a point in time.
Getting strong, consistent investment performance and setting stable, affordable contributions for employers is far more important – this is consistently one of our key objectives and is achieved successfully through our approach.
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