Pensions issues on a public sector outsourcing: costs, risks and why early negotiation is essential

Written on 18 Jun 2015

Why is early negotiation on pensions issues for an outsourcing contract essential?

When a public body outsources work to the private or third sector, the pensions responsibilities taken on by that body are usually onerous. The transferring employees are often given pension protection by way of the contractor being ‘admitted’ to the relevant public sector pension scheme.

In this post, we have only considered a situation where the relevant public sector pension scheme is the Local Government Pension Scheme (the “LGPS”). This is because it is this most common pension scheme encountered on this type of arrangement. The issues which arise with other public sector pension schemes will be similar, but not identical, to those identified in this post.

For the contractor, the LGPS route presents the possibility of significant and uncontrollable pension costs and risks arising. These can include high employer pension contribution rates (often in excess of 20% of salary) and the possibility of substantial ‘strain costs’ and ‘exit payments’ arising.

In this post we want to highlight to contractors and public sector bodies alike that these issues should be dealt with at an early stage of the tender process, so that proper negotiation about controlling the associated costs and risks can take place. This is in order for contractors to try and ensure that the work they take on remains profitable and is not scuppered by unexpected pensions costs, but also so that public sector bodies can carry out an efficient and fair tender process, with no pensions surprises coming out of the woodwork later down the line.

Background – pension protection requirements

Given the relative generosity of the pension schemes enjoyed by most public sector employees, the treatment of their benefits following a transfer to a contractor should be a key consideration in outsourcing transactions. Because of this, protecting pension benefits for former public sector staff transferred to private or third sector employers is a political imperative.

This protection has been granted in the form of a body of government guidance and directions built up over the last decade and a half, referred to collectively in this post as “Pensions Protection”.

Broadly speaking, Pensions Protection requires that outsourced public sector staff should be able to either continue to accrue pension benefits in the public sector pension scheme they were members of, or in an alternative “broadly comparable” pension scheme.

This post considers transferred staff being provided with continued access to the LGPS. If there is sufficient interest, we will write a further post about the issues which can arise with other public sector schemes and on setting up a broadly comparable scheme.

The issue we have been encountering recently…

In order for the Pensions Protection requirements to be complied with, it is possible for most contractors to be admitted to participate in the LGPS, so that the transferred staff can remain as members of the LGPS.

The default position on admission to the LGPS for a contractor is that it (as the “admitted body”) will take on responsibility for all pension costs and risks on entry into, during and at the end of its participation in the LGPS. These costs and risks can be very significant indeed and are often material in comparison to the value of the outsourcing contract itself.

It is possible for a commercial agreement to be reached between the parties such that these costs and risks are shared in some way (this is often referred to as a “cap and collar” type arrangement). However, we often encounter situations where the pensions costs and risks are only considered properly after the tender process has been completed.

Once an outsourcing contract has been awarded, there is often very little scope to agree to any sort of cost and risks sharing. This is largely because it would be prohibited by procurement law, which binds public sector bodies (in summary, this is to avoid any unfairness to other bidders who were unable to take account of the benefits of such sharing).

The four main LGPS issues to consider before and during the tender process

There are broadly four different areas of LGPS costs and risks that all parties should be aware of and which should be considered before and during the tender process:

  • Employer contributions: the admitted body will be required to contribute in respect of the transferred staff who retain their LGPS membership. The contribution rate is likely to be far higher than anything the contractor will be used to (often in excess of 20% of salary). The rate can also go up during the lifetime of the outsourcing contract.
  • Strain costs: additional and often very substantial lump sum payments to the LGPS may fall due from the admitted body in a number of circumstances where LGPS benefits in respect of the transferred staff are either enhanced or unreduced despite being paid early (these are known as “strain costs”).
  • Exit payments: at the date the admitted body stops participating in the LGPS for whatever reason, a payment is likely to fall due to the LGPS (this is known as an “exit payment”). The exit payment is linked to the LGPS deficit for the transferred staff at the time of the exit and it is likely to be quite a volatile and potentially substantial figure.
  • Other on-going costs: there are various other costs associated with being admitted to the LGPS, including for setting up a “bond” (to protect the LGPS in the event of the admitted body becoming insolvent) and for the payment of various LGPS actuary calculations throughout the life of the outsourcing contract.

A possible solution – cost and risk sharing

With all of these start-up, strain, exit and other on-going costs and risks, the default position is that the admitted body will be responsible for them.

However, it is entirely possible for the parties to agree commercially between them, under the terms of the outsourcing contract (or separately), that they will share these costs and risks.

For example, the parties could agree that:

  • the admitted body’s employer contribution rate will be capped at a certain percentage, with the remainder covered by the public sector body;
  • the public sector body will meet a certain proportion of the cost of obtaining a bond or any actuarial valuations which the admitted body is required to obtain in connection with its admission to the LGPS;
  • the admitted body will only be required to meet strain costs where they were triggered by matters within its control; and
  • the cost of any exit payment due from the admitted body on termination would not be claimed but instead subsumed back into the LGPS.

As already mentioned, the important point here is that the negotiation and agreement of these measures happens during the tender process and not after a contract has already been awarded. Once the tender process has been completed, procurement law (which binds public sector bodies) will largely prohibit any material changes of this type to the terms of the outsourcing contract.

It should be noted that we have seen this issue arise on both sides, in terms of public sector bodies not being fully aware of these issues and not providing enough pensions information at the bidding stage, along with where contractors have largely ignored pension costs and risks until after they have successfully been awarded an outsourcing contract.

Please do get in touch if you think any of these issues are relevant for you. In our experience, we will be better placed to assist the earlier we are involved.