When will the Fund become cash flow negative?

Transcription

1 LONDON BOROUGH OF BARKING AND DAGENHAM PENSION FUND 001 When will the Fund become cash flow negative? Addressee This paper is addressed to the Officers and Elected Members of London Borough of Barking & Dagenham as administering authority for the London Borough of Barking & Dagenham Pension Fund ( the Fund ). This report should not be released or otherwise disclosed to any third party except with our prior written consent, in which case it should be released in its entirety. We accept no liability to any other party unless we have especially accepted such liability in writing. Introduction This paper was requested by the Pensions Panel on 13 th December 2011 to assist with the assessment of the Fund s future cash flows and how these may impact investment decisions in the future. This paper is set out in the following sections: Scope of advice What is cash flow negativity and does it matter? Data, assumptions and methodology Modelling results Investment considerations Conclusions and next steps Reliances and limitations Appendix - Data summary Scope of advice This paper has been prepared by Hymans Robertson LLP in our capacity as actuaries and investment consultants to the Fund, in order to provide the Administering Authority with an indication as to when benefit payments from the Fund may exceed contribution income over the next 21 years. In particular, this is considered within the context of recent large scale public sector redundancy exercises and the potential for a significant increase in the number of members opting out of the Local Government Pension Scheme as a result of the difficult current economic environment. What is cash flow negativity and does it matter? A fund can be considered cash flow negative when the fund s outflows exceed its income. For the purpose of this paper, we have considered the Fund s income to consist of employer and employee contributions but have excluded investment income. The Fund s outflows are the benefits payable to the members and their dependants (pensions, retirement lump sums, death in service benefits etc). The contribution and investment strategies for most LGPS funds, including the Barking & Dagenham Pension Fund, are set on a long-term basis. They generally assume that a significantly higher degree of investment risk may be taken than in most private sector schemes in pursuit of higher returns. This is based on not only the security of members benefits and strength of employer covenant, but because the funds are still open and, until recently, growing. As a result of LGPS funds growing nature, cash flow has remained positive and funds have not been forced sellers of assets when investments fail to deliver the anticipated returns.

2 LONDON BOROUGH OF BARKING AND DAGENHAM PENSION FUND 002 Knowing when the Fund is likely to pay out more in benefits than it receives in contributions is important because it will in due course have implications for liquidity management, the funding strategy and the investment strategy of the Fund. In addition, for many funds, income is automatically reinvested. Therefore, any changes in the balance between contributions and benefits will have cash flow management implications. Many local authority funds are anticipating a step change in the membership as a result of the following factors: reductions in local authority budgets have led to wide scale redundancy exercises within local councils; there have been widely publicised discussions around increasing employee contribution rates for the LGPS, which may lead to an increase in the number of members that choose to leave the Local Government Pension Scheme ( opt out ). This may be a result of the Pensions Reform which is still ongoing and it remains to be seen how this will impact the active membership; there is some evidence (largely anecdotal) that members are already opting out in greater numbers due to their own financial circumstances. The Administering Authority therefore believes there is the potential for a reduction in the number of active members in the Fund over the next few years (with a corresponding increase in the number of deferred pensioners and pensioners) which could in aggregation become material. This could accelerate the time when the Fund becomes cash flow negative as a result of: a decrease in contribution income (although this may be partially mitigated by payments expressed in monetary terms as opposed to % of payroll); and an acceleration in the timing of the benefits payments as some of the members being made redundant may be entitled to early retirement, therefore receiving benefits earlier than anticipated. Data, assumptions and methodology To consider the effect of a reduction in the active membership of the Fund on its cash flows, we have modelled two separate scenarios, as follows: 1 The Fund s active membership remains stable (note we have assumed stability at December 2011 levels - there has already been a fall in active membership since the last formal valuation); 2 There is a 6-7% per annum reduction in the Fund s active membership for the first three years as a result of redundancies and opt-outs combined. Data The starting point for each scenario was the membership data at 31 December 2011 provided by Justine Spring for the recent data cleansing exercise. No changes were made to this data for scenario 1. The membership for scenario 2 was obtained by assuming an immediate 20% reduction in the Fund s membership at 31 December Since details of the actual leavers are uncertain, the active leavers were chosen at random by ordering them by age and selecting every 5 th member. These members were then assumed to become either deferred pensioners or pensioners depending on their age. Active leavers over 55 years of age (and thus entitled to redundancy early retirement on unreduced benefits) were changed to pensioners. Active leavers under the age of 55 were changed to deferred pensioners. Pensions for these members were then estimated based on the salary and service of the members at 31 December 2011 (assumed date of leaving).

3 LONDON BOROUGH OF BARKING AND DAGENHAM PENSION FUND 003 It should be noted that members aged over 55 who opt out are not entitled to early retirement and would become deferred pensioners. However, it has been assumed for simplicity, that all active leavers aged over 55 will become pensioners on unreduced benefits. This is a reasonable assumption as we would expect those members opting out to be further from retirement, as in general, younger members will be less concerned about their pension than older members. Also, a different age profile of the 20% leavers could alter the projections. It should be noted these are purely illustrative, and not necessarily indicative of likely outcomes. A summary of the membership data used under each scenario is shown in the appendix. Benefit outgo The benefits outgo assumptions only allow for benefit payments in line with the valuation assumptions, i.e. expected lump sums and pensions on retirement and death. We do not anticipate transfers out (or in) in the valuation so no allowance is made for either of these in our projections. The cash flows do not allow for actual economic experience since 31 December The annual cash flows are shown for each year following 31 December 2011, (so the year 1 cash flows are payable during the period 1 January 2012 to 31 December 2012). The cash flows are assumed to be paid midway through their respective period. We have shown cash flows separately for active members, deferred pensioners and pensioners at the calculation date. No allowance is made for members changing category after 31 December 2011, i.e. pension payments for members assumed to retire after this date continue to be shown as active benefit payments. Contribution income We have included estimates of contribution income assuming that members continue to pay 6.8% of pay. The employer contribution rate certified for the London Borough of Barking and Dagenham at the 2010 valuation was 19.5% for the year 2011/12, rising by 0.5% p.a. for the following 2 years. Since the Council is by far the largest employer in the Fund, we have used these rates for the first 3 years of modelling. At the 2010 valuation, the common contribution rate was calculated as 24.4%. From year 4 onwards, we have assumed that the employer contribution rate continues to increase at 0.5% p.a. (in line with the stabilisation strategy in place at the 2010 valuation) until it reaches 24.4%. It is likely contributions will vary from these levels. Please note that although the Council and certain other employers have part of their contributions expressed in cash terms (rather than % of payroll), this varies by employer and is therefore beyond the scope of this exercise to model accurately. We have therefore adopted the simpler % of payroll approach for the whole of the Fund, without modelling future fluctuations in funding level and hence employer contributions. Note that we have assumed that the total of employer and employee contributions will remain the same should employee contributions be increased. In practice, there is currently no power to reduce employer contributions between valuations and the extent of any reduction from the next valuation would be dependent on a number of other factors. However, in the absence of any firm details on member contribution increases, we believe the approach we have taken is reasonable and should not materially affect the results of our analysis. In any case, it is increasingly unlikely there will be any increases in employee contributions. New entrants During the modelling period we would expect natural membership reductions through voluntary leavers and retirements. To keep the membership stable, we have assumed new entrants would join the Fund and replace the departing active members. In modelling cash flows for new entrants, we define a replacement ratio as being the proportion of pensionable salary joining each year to the salary leaving each year. We have assumed a 100% replacement ratio over the next 22 years i.e. the salary roll remains flat over the period.

4 LONDON BOROUGH OF BARKING AND DAGENHAM PENSION FUND 004 Note that the 20% reduction in membership is applied before the new entrants replacement assumption is made. Therefore the 100% replacement ratio only applies to the reduced active membership. The projected cash flow position could be markedly different if a different replacement ratio was assumed. The new entrants joining are assumed to be spread appropriately between ages 25 and 64 with an average at age 37. The demographic and salary assumptions that apply to the new entrants are based on those for the existing members but have been simplified. Despite the simplifications, we believe that these assumptions are reasonable given the highly significant uncertainty associated with the level of new entrants. Assumptions The financial and demographic assumptions used to project the benefit payments from the Fund are those underlying the final results of the 2010 actuarial valuation, updated to reflect market conditions at 31 December For further details of these assumptions, please revert to the 2010 formal valuation report dated 31 March Cash flows have been produced on a single set of deterministic assumptions. Please note that using different assumptions would produce different results. Modelling results The graphs below show the results of the modelling. Scenario 1 (no reduction in active membership) Projected cashflow ( m) Pensioner outgo Deferred outgo Active outgo New entrants outgo Contributions It can be seen from the full membership cash flows graph (scenario 1) that estimated contribution income is broadly expected to balance benefit outgo for the entire period considered, but with small negative cash flows expected during 2013 and As discussed above, this assumes that employer contributions increase by 0.5%p.a. from 19.5% in 2011/12 rising to 24.4% in 2022/23 and beyond. Employee contributions are also fixed at the current rate. The overall cash flow position is therefore one that is broadly neutral over the entire period, although it is expected to be more positive for 5 years commencing in This would suggest that if the contributions towards the Fund did not increase by 0.5% p.a. to 24.4% the blue line representing income would fall and the Fund may be in cash flow negative position even where the active membership stabilises at the current levels.

5 LONDON BOROUGH OF BARKING AND DAGENHAM PENSION FUND 005 Scenario 2 (6-7% per annum reduction in active membership over the next three years) Projected cashflow ( m) Pensioner outgo Deferred outgo Active outgo New entrant outgo Contributions The chart for scenario 2, which assumes a 6-7% per annum reduction in active membership over the next three, the Fund becomes cash flow negative immediately as a result of lump sum payments made to members receiving immediate payment of pension. The Fund remains cash flow negative throughout the modelling period. This is shown in more detail in the chart overleaf. When compared with the Scenario 1, the following should be noted: 1 There is an increase in the level of deferred and pensioner benefits payable from 2011 as a result of a proportion of the actives being converted to deferreds and pensioners with unreduced benefits; 2 There is a decrease in the level of active benefits due to 20% of the active members no longer accruing benefit after 2011 (and therefore giving rise to lower benefits); 3 There is a 20% fall in the contribution income due to the reduction in the active membership; and 4 The most significant factor is the fall in contributions.

6 LONDON BOROUGH OF BARKING AND DAGENHAM PENSION FUND 006 Scenario 2 Resulting negative cash flow 12 Negative cashflow ( m) Scenario 2 results in additional cash flow requirements of around 8-9 million per annum over the next three years, then this amount falling to 6-7 million for a further two years. If assets were valued at 550 million, then these cash flow requirements represent in the region of 1-1.5% per annum of the assets. The investment implications of this are considered below. Investment considerations If the actual outcome was as described in scenario 2, the Fund would need to rely on the assets straight away in order to meet the gap between contributions and benefit outgo. However, the amount required is relatively modest compared with the total value of assets. In this situation, the Administering Authority would need to consider the following: Carefully monitor actual ongoing cash requirements, factoring in the expected amount and timing of investment income. Consider whether the investment strategy planned for implementation in 2012 would be suitable to provide an adequate income without being forced to sell assets, possibly when asset prices are depressed. If assets are sold at depressed prices, then the remaining assets will need to work even harder. An obvious source of cash flow from the portfolio would be to retain share dividends and/or bond coupons rather than reinvesting them with the managers. The Fund is currently planning to have around 300 million invested in UK and global equities once the absolute return and infrastructure managers are in place. Based on a dividend yield of circa 3.5%, the equity portfolio would be expected to generate income of around 10 million, which would be sufficient to meet the expected shortfall under scenario 2 for the foreseeable future. Consider the timing of income received from the portfolio and when regular additional cash flow is required. Factor the actual changes in membership and contributions into an asset/liability review to determine an appropriate investment strategy at the same time as the next actuarial valuation, due as at 31 March Consider the effect of other membership movements, including bulk transfers, large redundancy exercises, the flow of new entrants and the effect of employers leaving the Fund to assist in predicting ongoing cash requirements.

7 LONDON BOROUGH OF BARKING AND DAGENHAM PENSION FUND 007 Conclusions and next steps In our view the Fund is at best in a cash flow neutral position, but is at risk of moving to a cash flow negative position. It would not take much of a change in active membership to result in a cash flow negative position as a result of lower contributions into the Fund. Therefore, we would recommend that the Fund should monitor the effect of employer redundancy exercises, the flow of new entrants and opt outs to help anticipate when the Fund will become cash flow negative. The next steps for the Fund are: (a) (b) (c) (d) (e) (f) to consider whether further analysis is appropriate for example, by considering different levels of reduction at the whole Fund level or by carrying out analysis at employer level (since some employers will already be cash flow negative and, due to the operation of a single investment strategy, this will lead to an element of cross-subsidy between employers 1 ); to monitor membership changes and their effect on the Fund s cash flow position; to consider whether there are any other likely factors which might exacerbate the cash flow position or have an effect (such as the removal of admitted body status for future outsourcings); to consider whether any of the income generated by the assets and currently reinvested should be used to meet benefit payments; to consider whether any changes to the investment strategy is required with a move towards income generating or less volatile assets; and to consider whether unitisation may be an appropriate option for the Fund in the future to permit different investment strategies between employers. As you will be aware, the Government set up an independent review of public sector pensions, including the LGPS, chaired by Lord Hutton. Under consideration by Lord Hutton was the idea of increasing employee contributions and changes to the benefit structure of public sector pension schemes. The modelling results in this report do not allow for the possible effects that may occur from increasing employee contribution rates or benefit changes recommended by Lord Hutton as these have still to be agreed and implemented. Reliances and limitations This document should not be released or otherwise disclosed to any third party without our prior consent, in which case it should be released in its entirety. Hymans Robertson LLP accepts no liability to any other party unless we have expressly accepted such liability. The cash flow projections are based on a specific set of deterministic assumptions, which are highly unlikely to be borne out exactly, but which were deemed appropriate for funding purposes. They do not represent all possible cash flows; in particular no allowance is made for transfers in or out. Any party must accept full responsibility for establishing that the cash flows are appropriate for the purpose to which they want to put them and any decisions that are taken based on their analysis. We cannot be held responsible for any losses sustained as a result of third parties relying on the cash flows provided, or if the cash flows are used for any inappropriate purpose, for instance: directly for investment strategy changes, or at individual employer level. 1 This cross-subsidy is not new and is not, per se, an issue of concern, however as conditions change the Administering Authority may wish to better understand the extent and implications of the cross subsidy.

8 LONDON BOROUGH OF BARKING AND DAGENHAM PENSION FUND 008 The extent of the deviations from the assumptions underpinning the cash flow projections depends on uncertain economic events as well as other factors that are not known in advance such as members decisions, variations in mortality rates, retirement rates and withdrawal rates, fluctuations and rates of salary increase, changes in the regulatory environment and possible changes in retirement benefits. These other uncertainties are not necessarily related to any particular investment or economic eventualities. Two of the important uncertainties are the rate of pension increases, the vast majority of which increase at the annual increase in CPI inflation, and the extent to which members elect to exchange pension for cash at retirement. The cash flows provided assume that 50% of members retiring will opt to take the maximum permissible amount of tax-free cash (equivalent to 75% in the post-april 2008 scheme). In summary, it should be noted that there is significant uncertainty in the cash flows both into and out of the Fund, particularly the benefit outflow, which are largely unrelated to investment conditions. The following Technical Actuarial Standards 2 are applicable in relation to this report: Pensions TAS TAS M - Modelling TAS R Reporting; and TAS D Data. Barry McKay FFA Mark Freeman, Senior Investment Consultant 1 March 2012 For and on behalf of Hymans Robertson LLP 2 Technical Actuarial Standards (TASs) are issued by the Board for Actuarial Standards (BAS) and set standards for certain items of actuarial work, including the information and advice contained in this report.

9 LONDON BOROUGH OF BARKING AND DAGENHAM PENSION FUND 009 Appendix - Data summary Full membership details for Fund Summary of membership as at 31 December 2011 Actual Pay / Average Pay / Pension p.a. Pension Number Average Age* ( 000) ( ) Active 4, ,836 22,427 Deferred Pensioners 4, ,158 1,745 Pensioner 4, ,105 4,954 20% Reduction in active membership details for Fund Summary of membership as at 31 December 2011 Actual Pay / Average Pay / Pension p.a. Pension Number Average Age* ( 000) ( ) Active 3, ,095 22,280 Deferred Pensioners 5, ,495 2,099 Pensioner 5, ,043 4,963 * Average age is liability weighted Notes: in scenario 2 we have allowed for the reductions shown in the number of members. By removing every 5 th active member there is a small effect on the average age, salary and service of the remaining active membership (as well as a change in the deferred and pensioner membership). In practice it is possible that redundancies or opt-outs might be concentrated amongst specific groups (e.g. over 55s for the former or lower paid, younger members of the latter). No allowance has been made for such concentration in our analysis.