Embracing Prudence

2025 funding levels have risen

Actuarial advisers are now giving their first estimates of 2025 funding levels to LGPS funds in England and Wales.  Asset prices have gone up since 2022 (and even further since the 31^st March valuation date), while higher bond yields have resulted in lower liabilities.  As a result, many LGPS funds are finding themselves with substantial surpluses, and there is an active debate what to do with them. 

Note, however, that ‘many’ does not mean all, largely because of the different discount rate methodologies used by different actuaries.  I am aware that some funds will see unchanged or lower funding levels.

Why Prudence has a role to play

The funding level is influenced by how much prudence actuaries consider appropriate to incorporate into the discount rate.  That may in turn be influenced by the demands and pressures of their clients.  For example, one way to ‘solve’ the problem of an excessively high funding level is to use more prudence and reduce the discount rate, thereby raising the liabilities valuation. 

The case for more prudence traditionally relies on emphasising the sustainability of contributions over affordability.  A higher contribution level today reduces the likelihood of further increases tomorrow.  However, excessive prudence results in contributions being higher than are needed, at least in the short term.  With local council budgets under such pressure, that is undesirable.  With the aggregate LGPS funding level likely to be in the region of 120%, the case for more prudence becomes harder to justify, because the buffer against things going wrong is larger.

Prudence as compensation for unrealistic equity return forecasts

Actuaries have increased levels of prudence in the 2025 valuation.  One reason they give is that the long term expected returns used in their models for risky assets such as equities looks on the high side.  Different actuaries will use different methodologies, but they tend to rely on the equity risk premium.  The risk premium does not change, so the required return on equities must rise when the risk-free rate (i.e., the redemption yield on gilts) goes up.   

In the real world, with equity valuations close to all-time, it does not look logical to input higher return numbers into actuarial models.  History says that equities grow in the long term, but there have famously been periods when they have gone sideways.  The Dow Jones index only recovered its peak 1929 level in November 1954, 25 years later.  The TOPIX 500 index in Japan only beat its 1989 high in August 2025, nearly 36 years later.  

Quite apart from valuations, lower economic growth in the West is another reason to expect lower returns from equities.  Emerging markets may make up some of the deficit, but funds tend not to be invested as heavily in them.

Actuaries are understandably reluctant to change the models they have used for decades, and some have therefore increased their allowance for prudence.  This has the effect of reducing the discount rate and compensates for the unfeasible equity return forecasts by increasing the valuation of liabilities.

Does Prudence have a rival?

Instead of embracing prudence, LGPS funs have the alternative of reducing contribution levels further.  Given the pressures on local government finances, which would certainly be popular in towns and borough halls.  In practice many funds, perhaps most, are proposing to do both.  Could they go further?

Higher than expected inflation is the largest risk to LGPS funds

The case for higher levels of prudence rests on more than just unfeasible expected return estimates.  By far the largest risk to LGPS funds’ ability to pay pensions is inflation trending at a higher rate than the actuaries have inputted into their models (around 2.7%).  There seems to be tacit acceptance among central banks who are cutting rates while inflation is well above 2% that the real inflation target is higher, perhaps 3% or even 4%.  Higher inflation would certainly help indebted governments.

Over 15 years, the real value of money at 2% inflation declines by just over a third.  At 3% it falls by rather over 50%.  At 4% it reduces by 80%.  Pension fund liabilities will (other things being equal) rise similarly.  That is why it matters whether inflation trends at 2%, 3%, or 4%.  If central banks and governments have given up on the 2% target, then pension funds need to build in a bigger asset buffer for the future.

The Government is the second largest threat to pension funds

The second reason for prudence is the increased likelihood of government action detrimental to pension funds generally.  It is no secret that western governments are short of money and that pension funds have accumulated significant assets.  In the U.K., we have over the past 25 years seen dividends taxes introduced, the size of pension pots limited, and the inheritance tax perimeter encircling personal pension funds.  But so far the measures have largely been focused on pensioners rather than pension funds.

Today governments are greedily eyeing up pension funds.  In the U.K. they are encouraging – if that is the right word – pension funds to invest in private equity and U.K. assets.  In the U.S. the risk-free rate is being distorted because the Treasury is financing nearly a quarter of its refinancing needs through non-coupon-bearing T-bills rather than Treasuries.  The reduction of supply has the effect of reducing the yield on Treasuries at the ten-year tenor by about 75bps.

But the real threats would come from some form of default or capital controls.  It is easy to forget that until Margaret Thatcher’s abolition of capital controls in 1979 moving money in and out of the U.K. was a slow and complicated business.  It is quite feasible to imagine a government today, faced with a funding crisis and a collapse in confidence in its currency, choosing to reimpose capital controls.  

And we should not forget that most governments including the U.K. and the U.S. have defaulted on debt at some point in its history.  Hard defaults can take the form of non-payment, late payment, or a restructuring of terms to the detriment of bond holders.  If the definition of default is widened to include softer forms such as using regulatory tools and policies to force investors to buy bonds on sub-market terms, then every government has.  My point is not that this is inevitably going to happen, but that the risk of such actions, which are undoubtedly detrimental to pension funds, has risen.

Embracing Prudence

Pension funds, as the mantra goes, are there to pay pensions.  The LGPS is in a healthy funding position.  But as described above, the risks have grown (and I have not even mentioned those around pooling).  Tempting though it is to reduce contributions further, in my view we need to embrace prudence more tightly. 

If governments and central banks successfully stabilise their own fiscal and monetary position, so that the risks of higher inflation or default reduce, then it may be time to turn to her rivals.  But in the interests of our pensioners, until there are clear signs of that happening we need to exercise more prudence than was previously needed.