Appendix 1

Hampshire Pension Fund

Draft Funding Strategy Statement

1 Introduction

1.1 The Local Government Pension Scheme (Amendment) Regulations 2004 require the Hampshire Pension Fund to prepare and publish a Funding Strategy Statement (FSS) by 31 March 2005. This must be taken into account by the Fund's actuary when setting employers' contribution rates.

1.2 The Chartered Institute of Public Finance and Accountancy (CIPFA) has issued detailed guidance on the content and format of an FSS. This guidance has been followed in preparing this draft.

1.3 This FSS should be read in the context of the Fund's Statement of Investment Principles (SIP), which sets out in detail the Fund's investment arrangements and strategy. This is attached for information as an Appendix.

2 Consultation

2.1 All employers in the Hampshire Pension Fund have been given the opportunity to comment and contribute to this FSS. The Fund's actuary, Hewitt Bacon & Woodrow, has also assisted in its preparation.

3 Purpose of the Funding Strategy Statement

3.1 The FSS has two main purposes:

· To set out clearly the Fund's strategy for how it intends to meet its liabilities over the long term.

· To explain how the Fund will work towards the maintenance of stable employers' contribution rates.

4 The aims of the Fund

4.1 The Fund has four main aims:

· To make sure the Fund is always able to meet its liabilities.

· To enable employers' contribution rates to be kept as stable as possible and affordable for the Fund's employers.

· To manage the employers' liabilities effectively.

· To maximise the income from investments within reasonable risk parameters.

4.2 These aims are explained in more detail below.

To make sure the Fund is always able to meet its liabilities

4.3 The Fund's long-term solvency is the primary aim. Accordingly, employers' contributions will be set to ensure liabilities can be met over the long term.

4.4 Hampshire County Council as administering authority will make sure that the Fund always has sufficient cash available to pay pensions, transfer values to other pension funds, and other costs and expenses. Such expenditure will normally be met from incoming contributions from employees and employers and investment income to avoid the cost of selling any of the Fund's investments. The Fund reviews the position on a quarterly basis to make sure that sufficient cash is available to meet its obligations.

To enable employers' contribution rates to be kept as stable as possible and affordable for the Fund's employers

4.5 Achieving stability in employers' contribution rates requires investment in assets which `match' the Fund's liabilities. In this context, `match' means behaving in a similar manner to the liabilities as economic conditions alter. Index-linked and fixed interest investments are the best match for the Fund's liabilities.

4.6 Other asset classes, such as shares and property, offer the potential for higher long-term rates of return. A substantial proportion of the Fund's investments are held in these asset classes with the aim of increasing investment returns. However, these asset classes are more risky and can lead to volatile returns over short-term periods.

4.7 This short-term volatility in investment returns can lead to similar volatility in the Fund's solvency level in successive actuarial valuations, which in turn can mean volatility in employers' contribution rates. Such volatility can be reduced by the use of smoothing adjustments as advised by the actuary.

4.8 Maintaining stability in employers' contribution rates can run counter to the primary aim of ensuring solvency. There is a balance to be struck between the investment policy, smoothing adjustments used when carrying out actuarial valuations, and the stability of employers' contribution rates from one valuation period to the next.

4.9 The position can be even more volatile for admitted bodies with short-term contracts where the use of smoothing adjustments is less appropriate.

To manage the employers' liabilities effectively

4.10 The County Council as administering authority makes sure that the Fund's liabilities are managed effectively. This is achieved by commissioning actuarial valuations every three years as required by law, which determine the employers' contribution rates required to make sure liabilities can be managed effectively.

To maximise the income from investments within reasonable risk parameters

4.11 Returns which are expected to be higher over the long term than those from index-linked stocks are sought by investing in other asset classes such as shares and property. However, investment is restricted as specified in the Local Government Pension Scheme (LGPS) investment regulations.

4.12 Risk parameters are controlled by restricting investment to asset classes generally recognised as appropriate for UK pension funds. The potential risks of investing in the various asset classes are reviewed by the County Council from time to time with the assistance of the Fund's actuary and its investment managers.

4.13 The Fund has a scheme-specific benchmark which is set out in detail in the attached SIP. It sets out a central recommended asset allocation and limits within which the Fund's three main investment managers can operate. This benchmark excludes property, which is managed separately by a specialist manager, and for which there is a target allocation of 5% of the Fund's total value. The benchmark is designed to match the Fund's liabilities and limit as far as possible the volatility of employers' contribution rates, and is normally reviewed by commissioning an asset/liability study from the Fund's actuary after each triennial actuarial valuation.

5 Purposes of the Fund

5.1 The purposes of the Fund are:

· To pay out pensions and benefits, transfer values for fund members moving to other schemes, and other costs, charges and expenses.

· To receive contributions, transfer values for fund members moving from other schemes, and investment income.

6 Responsibilities of the key parties

6.1 The three main parties with obligations to the Fund are the County Council as administering authority, the other employers in the Fund, and the Fund's actuary.

The County Council's obligations

6.2 To collect employers' and employees' contributions and, as far as possible, make sure they are paid by the due date as specified in the LGPS regulations.

6.3 To invest surplus monies in accordance with the LGPS regulations relating to the investment of funds.

6.4 To make sure that cash is always available to meet the Fund's liabilities when they are due.

6.5 To manage the valuation process in consultation with the Fund's actuary, ensuring that appropriate timescales are agreed and that accurate data is provided.

6.6 To monitor the Fund's investment performance and funding level on a regular basis.

6.7 To prepare and maintain a Statement of Investment Principles and a Funding Strategy Statement.

Individual employers' obligations

6.8 To deduct contributions from employees' pay, and make employers' contributions at the rates specified by the actuary, paying both to the County Council by the due date.

6.9 To exercise discretions allowed to employers within the LGPS regulations.

6.10 To pay for agreed added years arrangements.

6.11 To keep the County Council fully informed of all changes to membership, or other changes which could affect the solvency position.

The actuary's obligations

6.12 To prepare actuarial valuations every three years as required by law, setting employers' contribution rates after agreeing assumptions with the County Council and having regard to this Funding Strategy Statement. The valuation will be prepared in accordance with the latest guidance issued by the Institute and Faculty of Actuaries, as far as it applies to the LGPS.

6.13 To prepare advice and calculations in connection with bulk transfers and individual benefit-related matters.

7 Solvency

7.1 The County Council will seek to ensure the Fund is solvent. Solvency is defined as being achieved when the value of the Fund's assets is greater than or equal to the value of the Fund's liabilities, based on current actuarial methods and assumptions.

7.2 The `projected unit' method of valuation will be used when assessing solvency, using assumptions appropriate for an ongoing pension fund with financially sound member employers.

7.3 The financial assumptions used to assess the funding level will have regard to the yields available on long-term fixed interest and index-linked gilt-edged investments.

7.4 The County Council has agreed with the actuary that the assumptions will make short-term allowance for the higher long-term returns that are expected on the assets actually held by the Fund, and accepts the risks to the Fund of such an approach if those additional returns fail to materialise. The position will be reviewed in subsequent three-yearly actuarial valuations.

7.5 The County Council has also agreed with the actuary that explicit smoothing adjustments can be used when measuring solvency. It is unlikely that the use of these adjustments will be extended to employers whose participation in the Fund is for a fixed period (for example non-local authority employers awarded contracts for the provision of local authority services).

8 Funding strategy

8.1 When an actuarial valuation shows that the Fund has a past service deficit based on this solvency measure, employers' contribution rates will be adjusted to target solvency over a period of years (the recovery period). A common recovery period of 40 years for all employers in the Fund has been set by the County Council in consultation with the Fund's actuary. The length of the recovery period is determined by balancing the Fund's solvency requirements against the financial strength of the main scheduled employers in the Fund.

8.2 The Fund's liabilities mostly take the form of benefit payments over long periods of time. The main scheduled employers in the Fund are financed through central and local taxation and can be viewed as very financially secure. As these employers ultimately underwrite the Fund's finances, the County Council has agreed a recovery period of 40 years which is longer than the average future working lifetime of the Fund's contributors. This is consistent with keeping employers' contribution rates as stable as possible. Were any member employer to participate in the Fund for a short period only it is unlikely that the County Council and actuary would agree a recovery period longer than the remaining term of participation.

8.3 Employers in the Fund are split into two groups: scheduled bodies and admission bodies. There are two common employers' contribution rates set for each of these groups, instead of individual contribution rates for each employer. The County Council accepts that this can give rise to cross-subsidies between employers. However, employers in the Fund are required to make up-front contributions determined by the actuary to cover the costs of early retirements, which is the major distinction between employers over time.

8.4 At each actuarial valuation, the County Council will consider whether new higher employers' contribution rates should be payable immediately, or phased in. The County Council discusses with the actuary the risks of adopting such an approach. The current policy is to phase in over a maximum of three steps within each valuation period. However, such increases may be phased in over forthcoming and subsequent valuation periods, on a year by year basis, if unusual and difficult budgetary constraints make this necessary, or if other changes are expected, up to a maximum of six steps.

9 Identification of risks and counter measures

9.1 The County Council's overall policy on risk is to identify all risks to the Fund and to consider the position both in aggregate and at individual risk level. Risks to the Fund will be monitored and action taken to limit them as soon as possible. The main risks are:

Demographic

9.2 Demographic risks include changing retirement patterns and increasing life expectancy. The County Council will make sure that the Fund's actuary investigates these matters at each valuation, or more frequently if necessary. The actuary will report to the County Council as appropriate. The County Council will then agree with the actuary any necessary changes to the assumptions used in assessing solvency.

9.3 If significant demographic changes become apparent between valuations, the County Council will notify all participating employers of the likely impact on their contributions after the next full valuation, and will review the bonds that are in place for transferee admitted bodies.

Regulatory

9.4 The risks relate to changes in LGPS regulations, national pensions legislation and Inland Revenue rules. The County Council will keep abreast of all proposed changes and, whenever possible, comment on the Fund's behalf during consultation periods. The County Council will ask the Fund's actuary to assess the impact of any changes on employers' contribution rates.

9.5 The County Council will then notify employers of the likely effect on employers' contribution rates at the next valuation, if they are significant.

Governance

9.6 This covers the risk of unexpected structural changes in the Fund's membership (for example the closure of an employer to new entrants or the large scale withdrawal or retirement of groups of staff), and the related risk of an employer failing to notify the County Council promptly.

9.7 To limit this risk, the County Council requires the other participating employers to communicate regularly with it on such matters.

Statistical/Financial

9.8 Risks to the Fund are posed by the performances of the various investment markets, the quality of the Fund's managers, variations in pay and price inflation, and the budget constraints faced by the Fund's employers.

9.9 The County Council regularly reviews these factors in conjunction with the actuary to decide whether the assumptions used in assessing solvency are still appropriate.

Investment returns

9.10 Assuming that investment returns will be in excess of those accruing on government bonds introduces an element of risk, in that those returns may not materialise. The County Council will monitor the underlying solvency position assuming no such excess returns to make sure the funding strategy remains realistic.

Smoothing

9.11 The use of a smoothing adjustment to the value of the Fund's assets introduces an element of risk, in that the smoothing adjustment may not provide a correct measure of the underlying position. This adjustment is reviewed at the end of each valuation to ensure it remains within acceptable limits.

Recovery period

9.12 Allowing surpluses or deficiencies to be eliminated over 40 years entails a risk that action to restore solvency is inadequate between successive actuarial valuations. The associated risk is reviewed in conjunction with the actuary as part of the three-yearly valuation process, to ensure as far as possible that the action taken to restore solvency is sufficient. In practice, the smoothing and damping arrangements described in this statement deal with this, although more recently the severe reductions in asset values and interest rates have increased the volatility in employers' contribution rates.

Stepping

9.13 Introducing increases in employers' contribution rates in annual steps rather than immediately introduces a risk that action to restore solvency is insufficient in the early years of the process. The County Council's policy is to limit the number of permitted steps to three, or, in exceptional circumstances, six. In addition, it accepts that a slightly higher final rate may be necessary at the end of the stepping process to help make up the shortfall.

10 Links to investment policy set out in the Fund's Statement of Investment Principles

10.1 The County Council has produced this Funding Strategy Statement having taken an overall view of the level of risk inherent in the investment policy set out in the Statement of Investment Principles (available on the web on www.hants.gov.uk/finance/pensions or from Dave Wilson, Corporate Finance Section County Treasurer's Department, Hampshire County Council).

10.2 Both documents are subject to regular review.

11 Future monitoring

11.1 The County Council plans to review this Statement as part of the three-yearly actuarial valuation process unless circumstances arise which require earlier action.

11.2 The Fund's solvency position will be monitored on an approximate basis at regular intervals between valuations in conjunction with the actuary. Discussions will be held with the actuary to establish whether any changes are significant enough to require further action, such as advising employers of the need for different employers' contribution rates after the next valuation.