Pension pitfalls for local government contractors

15th January 2021

Companies who are bidding for service contracts with local government should watch out for pension risks. These risks take the shape of pension funding employer costs in the Local Government Pension Scheme ("LGPS"). When bidding for service contracts these risks are real where local authority employees transfer to the private contractor for the duration of the contract term. Pension provision for transferring staff in the LGPS is a key commercial risk and should be addressed in the commercial contract terms, with appropriate professional advice taken (legal and actuarial).

Formal participation sign up

Contractors will be asked to sign up to formal participation in the relevant LGPS fund. They will be responsible for pension funding costs in respect of the transferring staff for the duration of the contract. These costs include payment of ordinary employer contributions (at rates set by the LGPS actuaries) and additional contributions triggered on ill health retirements and redundancy. In addition, at the end of the contract term, there will be a formal assessment of the scheme liabilities in respect of the contractor, and this could lead to a demand for what is called a deficit payment (where the liabilities exceed the notional fund assets) or a payment of a surplus (where the notional fund assets exceed the liabilities).

It is possible for the contractor to hedge again these risks by agreeing commercial terms with the outsourcing local authority (which will be responsible to the fund for these costs by default if the contractor fails to pay), by agreeing caps to employer contributions – commonly the contractor pays contributions up to the cap (and where the fund does not require any payment, the monies are still reimbursed to the authority). It is also possible to agree for the authority to indemnify the contractor for any deficit payments at the end of the contract. The contractor may be able to place safeguards to guard against other funding risks through redundancy and ill health of transferring staff – relevant factors here will be the age profile of the affected staff and the operation of the contract.

This is because since 2018 it has been possible for contractors to benefit from the payment of surplus in the Local Government Pension Scheme fund at the end of the contract term, under Reg. 64 of the LGPS Regulations 2013 (“Reg. 64.”). Initially Reg. 64 gave the exiting contractor an entitlement to payment of the surplus, regardless of whether any terms had been agreed in the contract for indemnity in relation to pension risk (called a “Pass-through“). From 2020 Reg. 64 was amended so that the fund has a discretion to pay to the exiting contractor any amount of the surplus, but there is no such entitlement. This amendment applied retrospectively back to where Reg. 64 first came into force in 2018.

Challenging position for older contracts

For some contractors (especially with older contracts which started before 2018 and ended before 2020 when Reg. 64 changed) the position is challenging. LGPS Administering Authorities tend not to want to pay out surplus funds to exiting contractors with these older contracts where there have been Pass-through agreements in place in the commercial terms. This goes against the requirements of Reg. 64, which does not preclude the payment of any surplus to such contractors with older contracts with Pass-through terms.

New contracts

For new contracts the position is simpler. Contractors have a wider range of choice, depending on their attitude to commercial pension risk. They may still want to be indemnified in respect of risks of deficit payments, which will involve building in a risk premium or discount to their commercial services, much like principles of insurance.

However, they may decide to take the risk of a deficit, and the upside of a surplus payment, and price the contract at a higher amount to reflect the fact that they are taking these risks. Key factors here will be to agree suitable funding position attributable to the contractor at the start of the contract. The authority may argue the risk premium should be less because the risks of a deficit for the contractor are offset by the chance of a surplus. Professional advice will be key to assist in the bidding process, especially where there are large numbers of transferring staff, which will impact on the Local Government Pension Scheme figures.

This article is part of the Employment Law Newsletter – Winter 2021

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