Ceasing participation in the LGPS: is now the right time?

Introduction

There are many different types of employers that participate in the LGPS, but not all have an ongoing obligation to remain in the Scheme. For those employers that can leave the LGPS (typically those that have an admission agreement in place) then deciding if and when, to cease participation in the Scheme can be a difficult decision.

A cessation event can have important implications for employers, potentially creating significant financial pressures if not managed correctly, but which can also free employers from a burdensome obligation if managed and planned for, appropriately.

Once an employer exits the LGPS the Fund Actuary will prepare an actuarial valuation of the employer’s assets and cessation liabilities in the fund. If a cessation deficit is present, then an employer will need to pay for this to terminate their pension obligations. This raises the question, ‘Is there a right time for an employer to leave the LGPS’?

Rising government bond yields

There are different valuation bases used to calculate employer liabilities in the LGPS. For determining primary and secondary contributions, the ‘ongoing’ valuation basis is used which generally has a discount rate broadly in line with the fund’s expected investment returns. However, under a cessation event, LGPS funds often use a discount rate reflecting the yield on government bonds, or ‘gilts’.

A gilts-based calculation will typically lead to a much higher liability figure. Yields on bonds are sensitive to interest rates and as interest rates have been at historic lows for some years now, this has led to high cessation deficits across the LGPS.

However, interest rates have risen in the UK in response to high inflation, this has significantly increased gilt yields and correspondingly reduced the cessation liabilities of LGPS employers. In some cases, employers may even find that they now have a surplus on a cessation basis.

This improvement in funding, which we expect to result in the lowest cessation deficits that employers will have seen for many valuation cycles, may be significant enough for employers to consider whether it is right for them to now leave the LGPS. Whilst the LGPS provides excellent pension benefits to its members, these may be viewed by some employers as too expensive for the overall growth and sustainability of the business.

Exit flexibilities

In September 2020, the LGPS Regulations 2013 were changed to incorporate two new repayment options. These are known as ‘Deferred Debt Agreements’ and ‘Debt Spreading Arrangements’. Both allow an employer to exit the LGPS and repay their cessation deficit over time, but there are some key differences between the two.

1. Deferred Debt Agreement (‘DDA’)

A DDA introduces a new type of employer status to the LGPS. A ‘deferred’ employer is an employer who has no active members and who defers the immediate repayment of their cessation deficit by way of a DDA.

An employer will pay (secondary) contributions to the fund, if required, and will experience the same investment returns as other active employers over the payment term of the DDA.

Employer contributions will typically be reviewed at each triennial valuation. The intention is for the employer to be fully funded on a cessation basis (through a combination of employer contributions and investment returns) by the end of the DDA period.

2. Debt Spreading Arrangement (‘DSA’)

Under a DSA, an employer’s cessation deficit is crystallised at the date the last active member ceases accrual, and then spread over an agreed term. Here, the employer has formally left the scheme, the cessation debt has been triggered, and employer contributions target the repayment of the deficit over a set period.

In contrast to a DDA, a DSA does not expose an employer to investment risk. A DSA gives an employer certainty over the contributions due, but it prevents an employer from potentially benefitting from positive future investment returns. As such, the employer is effectively paying a ‘premium’ for the certainty of guaranteed future contributions.

Every cessation is different

Before exiting the LGPS, employers should consider the following:

1. What is the amount of your cessation deficit and how will this be treated following a cessation?
2. Can another fund employer assume responsibility for your pension liabilities (e.g. by way of a subsumption agreement, potentially with a Local Authority)?
3. How has the fund assessed your employer covenant? Does the fund expect you to repay your cessation deficit immediately upon exit?
4. Can you afford the required contributions under either a DSA or a DDA?
5. Can you afford the DDA contributions if investment returns are worse than expected?
6. Which option is best for you and the long-term sustainability of your business?

The right time to leave the LGPS will therefore depend on several factors, including the fund’s approach to calculating the cessation deficit and the period over which the fund is willing to spread any payments. This period may depend on the fund’s understanding of your employer covenant and your ability to repay the required contributions. In addition, if suitable security over employer assets can be provided, then that may allow the fund to grant an employer a longer repayment period. There are various ‘levers’ which can be pulled by funds and it is vital that employers take specialist advice in this area if they are considering exiting the LGPS.