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As council pension funds prepare to set employer contribution rates for the next three years, excessive levels of prudence could see councils paying more than they need to, writes a partner at Isio.
There has been a fundamental shift in the fortunes of UK defined benefit pension schemes like the Local Government Pension Scheme over the last three years. This is because the value of their liabilities – what they need to set aside to pay out pensions in the future – has fallen by around 50%.
This applies to both trust-based pension schemes and the LGPS in the same way, but the impact is much bigger for the LGPS.
Why have the liability value falls been so significant? It’s because of the 3.5% pa rise in the yields on long-dated gilts – UK government bonds – since 2022. Arguably, pensions are like bonds – both give rise to guaranteed payments in future years.
This means that, whether or not a scheme is actually invested in gilts, an actuarial valuation using gilt yields with no allowance for investment outperformance is a strong reference point for assessing risk and future funding needs.
Insurance companies have to price pension liabilities very cautiously to meet their regulatory requirements and to protect their pension customers over their lifetimes. They base their pricing on gilt yields. Should the LGPS be more cautious than insurers?
I would argue not.
Low-risk index
One of the most important things a pension fund needs to know is whether its assets are sufficient to pay out pensions in the future. Actuarial valuations aim to work out a pension fund’s assets and liabilities.
If a pension fund has a funding position of 100%, its assets are just enough. If it is below 100% it has a deficit; if it is above 100% it has a surplus.
And one of the most important numbers used to calculate the funding position is the discount rate, which is used to estimate the present value of a pension fund’s future liabilities. The lower the discount rate that funds and actuaries use, the harder it is to reach 100%. A lower discount rate is more prudent.
Isio’s Low-Risk Index for LGPS (England & Wales) uses gilt-yield discount rates. It shows that the LGPS’s funding position has, in aggregate, improved from around 67% at 31 March 2022 to 126% at 31 March 2025.
The low-risk future service contribution rate – the amount that an employer has to pay to cover new pension entitlements that their staff will build up in the future – has reduced from around 50% to 15% of pay.
If we use these Index numbers as a reference point for the three yearly actuarial valuation of the LGPS which took place using data as at 31 March 2025 – the outcome of which will become clearer in the coming months – what might it mean?
£6bn annual saving
The typical way to calculate an employer contribution rate in an actuarial valuation is to take the past service surplus, which our low-risk model puts at £87bn, and utilise (or “spread”) it to adjust the future service contribution rate.
If we cautiously do this over around 30 years, it gives an average LGPS employer contribution rate of around 6% of pay. This is much lower than the current average employer contribution rate of 21%.
In the context of local government funding gaps … this amount of money is very material
This would represent a £6bn saving per year for LGPS employers.
Most of the £6bn would be for the benefit of local authorities, but schools and other employers providing local services would benefit too – a neat way of meeting local investment objectives.
In the context of the current local government funding gaps and the chancellor’s spending challenges this amount of money is very material.
Based on financial economics, it makes sense to allow for outperformance of gilts if you are invested in growth assets. Government borrowing is so secure that a gilt yield discount rate represents a risk-free rate, and so you should expect an outperformance premium for taking investment risk, especially over the very long-term.
The LGPS has, since pension scheme funding principles developed significantly in the 1990s, assumed there will be out-performance. The reality is that the allowance has been adjusted to help stabilise contributions and so it has shifted across valuations. But outperformance has always been assumed.
And if you cannot stand behind a discount rate with outperformance in it, it prompts the question – what is the point of having growth assets at all?
Prudence or over-caution?
Let’s come back to our 6%, the average employer contribution rate for the LGPS assessed on a low-risk basis.
This is calculated using gilt rates and so any contribution rate above this is, in effect, assuming that the LGPS’s asset returns will fall behind gilt yields. In fact, if, as I expect, the new average contribution rate lands at around 17%, this is equivalent to using a discount rate of a full 1% below gilt yields.
This would suggest that LGPS funds are being far too prudent in their approach to setting contributions.
Some people would reject this argument.
The right question to be asking is – is the increased risk acceptable?
They would say we live in an increasingly uncertain world, so LGPS funds should increase the level of prudence to protect them against unforeseen shocks that could cut the value of their assets.
For sure, we’ve got bigger geo-political challenges than most of us can remember, and continued uncertainty around UK growth and climate change to grapple with.
And yes, this might be a time to be more cautious, but there is no need to take discount rates below gilt yields. Instead, it might be reasonable to be more cautious about outperformance of growth assets.
Sometimes the fact the LGPS is an open scheme is considered as a risk factor. On the other hand, open schemes can focus on the very-long term in a more flexible way.
It is a truism that paying lower contributions now means an increased risk of higher contributions in future. But it misses the point. The right question to be asking is – is the increased risk acceptable?
One way to address this question is to note that there has always been a risk of contributions increasing, so how does the risk of contribution increases today compare with the risk at previous valuations (no hindsight allowed!)?
The same asset-liability models that are used to inform LGPS investment strategies can be used to measure this. And, spoiler alert, the likely outcome is that even with much lower contribution rates the risk of increases is much lower than it has been before.
Stability is broken
Making employer contributions stable may have served the LGPS well in the past, but it is not going to work this time as it will move effective discount rates significantly below gilt yields for the first time.
This means there is risk that the 2025 valuation will present, with early hindsight as soon as the actuarial valuation reports are available, as the LGPS not having sufficient faith in its investment strategy to deliver the long-term performance that the investment industry and the chancellor expect and local government needs.
This is a material and relevant debate because to reflect the £6bn a year market improvements would bridge the funding gaps that nearly all councils are facing and constitute a much better use of local government resources.
Steve Simkins, partner, Isio
This article first appeared in Local Government Chronicle here on 17 December 2025