Much has been written recently about the Universities Superannuation Scheme (USS). As with any issue where there is a diverse cast of interested parties and commentators; this leads to a spectrum of very different viewpoints and agendas. These include claims that student tuition fees will have to rise to prop up pensions – others argue that the deficit has been artificially inflated and the scheme is affordable in its current form. So, amidst the claims and counter-claims what should you believe? What are the facts that should be considered in this important debate?
The focus of debate has been on the size of the deficit in relation to pension promises for past service. While this is serious and needs to be addressed, it is not the only issue. The recent valuation also reveals that the cost of providing future benefits has increased from 26% of salaries (18% employer and 8% member contributions) to 32.6% – well above the maximum we see as a sustainable level both for individual members and employers. This means that to provide current benefits into the future the sums that employers and individual scheme members (university sector staff) would have to pay into the scheme would need to rise to unaffordable levels.
Why has this happened? Largely because economic changes, which could not have been predicted at the last valuation in 2014, have reduced future investment return expectations. This is a problem not just for USS but also for many other funded UK pension schemes.
A risk that employers cannot take
We should be under no illusion, this is not a problem that will go away if ignored. To retain the status quo would only serve interests in the short term. Without reform now, universities will likely be forced to divert funding allocated from research and teaching to fill a pensions funding gap, or if they did not, they would risk the sustainability of USS. The option of no reform is a dangerous gamble. It is a risk that employers cannot take.
It has been suggested that rather than increase contributions or move to a benefits structure that is affordable for the long term, USS should invest more aggressively for higher returns. This would increase the risk that, if the strategy failed, USS would need to call on universities and other higher education sector employers in USS for additional funding at a level most institutions would struggle to meet. It would also be highly unlikely to gain the approval of the Pensions Regulator, which, as well as making sure that USS can pay pensions as they fall due, is tasked with ensuring that the cost of the scheme does not threaten employers’ survival.
There have been numerous meetings between USS, employer and member representatives (UUK and UCU respectively) over the past year to feed into the valuation process and methodology used by USS. We are now approaching the end of USS’s formal consultation with employers on the valuation outcome and options for dealing with both the deficit and the rise in future pension costs. The next step is to reach an employer consensus on the way forward.
UUK, taking into account feedback received from USS employers, will be developing proposals to give the scheme stability and security, to ensure it remains affordable for individuals and universities, and continues to provide attractive benefits to current and future employees. Difficult decisions will need to be taken during the negotiation process, including the reform of future benefits. There are vital decisions that all involved need to get right to strengthen the sustainability of the scheme and avoid further rounds of uncertainty and change.
The recent Employers Pensions Forum (EPF) report sets out universities’ priorities for future pension provision. It is essential that we find a way to continue to provide pension benefits that staff value, within a sustainable framework with the flexibility to adapt to any future change in demands and behaviours. We owe it to current, future and past employees and, also – importantly – to our students to do so.
Discussions with USS and formal negotiations between employer and member representatives are expected to proceed through December 2017. Any agreed changes to member benefits or contributions will necessitate a full consultation with pension scheme members in February/March 2018.
6 responses to “Pensions – the importance of getting it right”
Coincidentally, and without realising that you had just published this piece on Wonkhe about USS, I posted the linked open letter to you on my blog. I wouldn’t revise my letter in the light of your piece. Rather, it confirms what I say, since it fails to engage with the critique of Test 1 and self-sufficiency in gilts. So I still stand by what I say here and look forward to EPF and UUK’s response to this challenge:
“It has been suggested that rather than increase contributions or move to a benefits structure that is affordable for the long term, USS should invest more aggressively for higher returns.”
This appears to be a reference to the approach that First Actuarial has proposed. It strikes me, however, as a somewhat tendentious and uncharitable characterisation. In a piece that was published on this website two weeks ago, I think I offer a more balanced assessment of this approach, in comparison with the approach that USS and UUK prefer. I would urge Finance Directors and other university senior managers to at least read my linked piece below (link #1), but ideally to read the 16 page paper by First Actuarial which I discuss (link #2):
We all agree on the importance of getting it right. The trouble is, what the UUK are proposing will not get it right.
We were told at the last two valuations, in 2011 and 2014, that the changes made then, including the deficit recovery payments, would solve the problem. At the time they ignored the advice of those experts who warned that, focussing on reducing risk by investing in gilts that would be guaranteed to produce a poor return, would not restore the scheme to good health but instead create a vicious circle of decline. Increased contributions would inevitably lead to the scheme’s closure. Well, that is the prospect we now have before us. There are no grounds to believe that what is being proposed will succeed.
Yet the UUK chief executive reveals an inability to learn from experience. UUK are in a hole and proposing to continue digging. They plan to shift the investment of members’ pension funds into loss-making gilts (their low rate of return is projected to be well below inflation) because they believe that will minimise risk. (They even refer to the self sufficiency liabilities of Test 1 as a ‘safe harbour’.) It will in fact increase the risk of the pension scheme substantially. That is a plan so obviously flawed as to be worthy of Baldrick at his most cunning.
The academic community, many of whose members understand the economics of pensions, have argued against the approach being followed. Our arguments are backed up by sound actuarial evidence based on a belief in pensions. But you and UUK have refused to engage in debate with us. You have so far failed to justify the basis of your proposed valuation or to listen to an alternative. Your attitude resembles that of the Holy Inquisition to Galileo.
The alternative we are arguing for is to recognise that the scheme is not – in actual fact – in deficit in the usual meaning of the word (one George Osborne would recognise – not enough income to cover outgo resulting in selling off assets or borrowing). Valuation should be done by looking at cash flows, income and outgo, on various scenarios and investment should be for the long term in the real economy (nothing “aggressive” about long term investment in productive capital) in order to gain the equity premium and participate in economic growth. You have refused to have an intelligent discussion of this with us.
Thank you for sharing your concerns about Universities Superannuation scheme and its valuation. There are a number of parties in the governance of the USS and it is important that we listen to each other and attend to each other’s concerns. I would like to address myself to yours.
First, some good news. You refer to the headline 32.6% cost of future benefit accruals. If you follow the link in Mike Otsuka’s response to First Actuarial’s paper on progressing the valuation, you will find that the 32.6% cost applies only in the year after the valuation date. USS has proposed a complex structure of the discount rate, and as this structure unfolds, the cost of future accrual comes down over the following 10 years, to 27.3%. That is not to say there is no problem, but the overall size of the problem is smaller than the 32.6% head line suggests.
I see two main concerns. One is the risk of the employers’ contributions going up. An unwanted increase in cost will result in either the employers’ contributions going up, or the members contributions going up or the members’ benefits cut, in some combination. This is an issue on which the employers’ and the members’ interests are aligned.
The second is highlighted in the heading “a risk that employers cannot take”, under which comes paragraphs about investment strategy and sustainability.
Were the USS to move down a path leading to an eventual closure to accrual, on whatever time scale, investment risks would be increased. A closed scheme has negative cash flow, creating a disinvestment risk which is not there in an open scheme. The investments would be rearranged to generate income with which to pay benefits and to protect against disinvestment risk. The return on such investments is likely to be lower, which means the contributions required in addition to asset income increases.
Closure of the USS leads to two things the employers don’t want: increased investment risk and higher contributions.
You can see a projection of USS’s cash flow in First Actuarial’s report. You will see there is no disinvestment risk in an open USS. Short term market falls are not harmful, because assets do not need to be sold to pay benefits. On the contrary, cheaper assets means more rewarding investment of the net positive cash flow. The need for income in addition to contributions to pay benefits is low and can be reliably delivered. The balance between contributions and benefits is prudent – contributions coming in are high relative to benefits going out. The investment return required to improve the USS’s funding level is highly likely to be achieved given time, and time is what an open scheme sponsored by strong employers has. An open USS has time and long term sustainability.
We have put together trial recovery plans based on the current contribution rate and benefits. The modification to the actuarial basis required to make ends meet are small. The UCU has our report on this, please talk to them about it.
Derek Benstead FIA
First Actuarial LLP
I’m pleased to see that Derek Benstead, from First Actuarial, has contributed to the comments thread, in response to Alistair’s comment that First Actuarial’s approach “would increase the risk that, if the strategy failed, USS would need to call on universities and other higher education sector employers in USS for additional funding at a level most institutions would struggle to meet”.
There is the following risk which Alistair may have in mind, which Derek doesn’t address above but does so in previous work.
Here’s the risk: for the triennial valuation, USS’s assets need to be marked to their market value on a particular day at the end of March every three years, in order to determine the asset side of the scheme’s asset/liability funding position. So the valuation of the assets, which plays a role equal to the valuation of the liabilities in determining the scheme’s funding position, is a hostage to fortune – e.g., whatever animal spirits determine the particular levels of financial markets on 31 March 2020.
This raises the following challenge for First Actuarial’s approach, which involves an investment in growth assets. The market price of growth assets is volatile. So there’s the problem, with a growth portfolio, that if there’s a fall in the value of the assets (e.g., a major drop in the stock market) before the valuation date, there is the fear that this might push the scheme into such deficit that the valuation would force high deficit recovery contributions.
First Actuarial address this problem in some earlier work: They maintain that the best estimate of returns on equity should be based on the internal rate of return (IRR) of the asset in question, which, in the case of equity, is the dividend yield (current annual income from dividends divided by asset price of equities), plus RPI (as implied by index-linked gilts), plus an assumed dividend growth rate over RPI. They describe and defend their IRR approach in their December 2016 paper (see pp. 2–10 of link #1 below). IRR-based valuation has the effect that a fall in asset values will be accompanied by a fall in the valuation of the liabilities. See p. 7 of the second link below, for a document prepared by First Actuarial in September 2015, where they model USS’s funding level, based on this IRR approach, as compared with USS’s gilts-based monitoring approach. Note that the funding level remains closer to full funding, with less volatility, on First Actuarial’s IRR approach.
It’s also worth noting that the market price of bonds, as well as growth assets, is fairly volatile, in spite of the characterization of gilts as the ‘risk free asset’.
“UK universities retirement fund ‘weaker’ than claimed, fears watchdog”
Story in today’s FT (behind a paywall) about a leaked letter from the Pensions Regulator to the chair of USS