August 17, 2018

The USS analysis of reliance is seriously flawed and biased against the scheme

Evidence to the Joint Expert Panel

by

Dennis Leech, Emeritus Professor of Economics, University of Warwick, 15 August 2018

The assessment of reliance on the employers’ covenant is fundamental to the valuation and funding of the scheme. If the likelihood of the employers being asked to make additional payments above the maximum they can afford is too high, then that spells too much reliance and there will have to be benefit cuts. The details of their approach to this calculation are set out in various USS documents, including the Draft 2017 Actuarial Valuation, 1 September 2017, and Proposed approach to the methodology for the 2017 actuarial valuation: response to the Valuation Discussion Forum, 22 November 2016, and formalized in their various Tests.

The reliance measure is the difference between the scheme’s assets and what is termed the ‘self sufficiency’ liability. Self sufficiency is the level of assets that would be required for a low-risk investment strategy with a low probability of ever needing further contributions to provide benefits. The self sufficiency liability is described by USS as a ‘safe haven’ because it could be covered by investing in government bonds that are completely safe. Self sufficiency liability is calculated using a ‘gilts plus’ discount rate (gilts plus 0.5 or 0.75%) regardless of the actual investment strategy of the scheme. Because current gilt rates are so very low due to government monetary policy, this gives an extremely large figure of £82.4 billion for the liabilities. The conclusion reached by the USS from this is that the reliance is near the maximum that the employers can support.

There are however, serious problems with this approach to reliance. The methodology is flawed in two important ways.

  1. Essentially what is at issue is a choice between two statistical hypotheses that have far reaching consequences that are very different: on the one hand, the scheme remains open indefinitely, and on the other, there is a high likelihood of it having to close at some stage in the not-too-distant future. An even-handed treatment that tested the two hypotheses fairly would use the method of scientific testing of statistical hypotheses. This has not been done and instead the USS approach has, in effect, been biased in favour of supporting the second hypothesis.

  2. The treatment of risk by the USS is not consistent. In particular no allowance has been made for the fact that risk is not an absolute factor like it would be in a gambling situation, but is conditioned by circumstances. It is different for each of the two hypothesis under consideration. Two types of risk need to be considered: that which depends on the particular hypothesis being tested and that which is independent of it. We can call these respectively endogenous and exogenous risk.
Mistaken testing methodology

The USS tests of the reliance of the scheme on the covenant amount to essentially testing two hypotheses against one another using statistical reasoning. Either the scheme remains open indefinitely, and continues as it has been until now, or it eventually changes fundamentally and makes the journey to self sufficiency or closure. However, in their analysis, the USS have not treated both hypotheses in the same way, as a truly scientific approach would warrant. The hypothesis that the scheme remains open without undue reliance has not been thoroughly investigated and has been rejected nonetheless.

The scientific approach to testing a statistical hypothesis proceeds by first deriving the probability distribution of the relevant test statistic on the assumption that the hypothesis is true. The decision about whether to accept or reject the hypothesis is made by partitioning the theoretically possible values of the test statistic into two sets, the acceptance region and the rejection region. The test statistic is then computed and a decision made depending on where its value falls.

The test statistic in this application is the liability and the decision rule used is to compare the liability with the assets plus the amount of reliance that the institutions can afford. The affordable maximum reliance has been fixed at around 7 percent of payroll over 40 years.

The key point that the USS has ignored is that the liability depends on the particular hypothesis being assumed true and tested. If the scheme is regarded as continuing indefinitely then it can invest in high volatility assets to gain the higher returns that such assets will bring. High volatility is not a source of risk in this case. And if the scheme is cash positive, as the USS is and is forecast to continue to be indefinitely (see the paper by Salt and Benstead) it need not match the risk of the assets held with the liabilities. As Salt and Benstead put it:

“Being an open scheme brings significant investment advantages, which can be exploited to the benefit of the employers and members. The investment time horizon is infinitely long. An open scheme pays its benefits from contribution and asset income without any need to sell investments. If the asset income is sufficient, fluctuations of their market value is relatively unimportant.”(p8)

It follows that the liability for an open scheme will be appropriately calculated using a – higher - discount rate reflecting the expected return on the assets held in the investment portfolio. That will give a low figure for the liability.

On the other hand, if the scheme is seen as being in danger of closure, the volatility of the asset prices assumes central importance, and becomes risk. Under this ‘weak covenant’ hypothesis there is a danger that the scheme will have to sell off assets to pay benefits at some time in the future when prices are low and will be unable to pay the benefits in full. Therefore on this hypothesis the scheme needs to invest in – low volatility - assets that match the liabilities in terms of risk and return. The appropriate discount rate is therefore the - low – bond rate. The USS ‘self sufficiency’ portfolio is calculated on this basis.

The proper assessment of reliance therefore requires two different calculations of the liability: one assuming a strong covenant, that uses a liability based on best estimate returns from an income-seeking investment portfolio (such as the current one); and one for a weak covenant, that uses the self-sufficiency gilts-plus approach, assuming a low risk portfolio. Both calculations should be done. If they both give a reliance figure that is probably above 7 percent of salary, then the result is clear that the employers are unable to continue to support the scheme.[1]

It seems likely however that if the two approaches are applied correctly by the USS they will give different results. The assets on the valuation date of 31 March 2017 were £59.9 billion and the best-estimate liability figure was £51.7 billion, giving a surplus of £8.2 billion, and therefore no further reliance on the employers is indicated.[2] On the other hand, the self-sufficiency-gilts-plus liability was £82.6 billion, a reliance of £22.6 billion, larger than the target reliance of £10 billion.

The conclusion is that the result of the tests depends on what is assumed. On the hypothesis that the scheme remains open the inference is that it does not place particularly great reliance on the employers, and therefore we should accept the hypothesis and keep the scheme open. On the other hand, on the hypothesis that the scheme does not remain open indefinitely, there is likely to be high reliance on the employers.

Keeping the scheme open indefinitely would seem to be a perfectly reasonable and prudent course of action that would require neither increases in contributions nor cuts in benefits.

Inconsistent idea of risk

When valuing pension schemes it is important to separate the risks they face into two types: those that exist independently of the valuation, exogenous risks; and those which are consequent on it, what might be called endogenous risks.

A scheme in deficit is threatened by an existential risk due to the deficit itself, whatever other risks there may be. The need for the employer sponsor to make additional payments into the scheme threatens the company’s solvency and weakens the covenant. Many schemes have closed as a result of the actuarial valuation showing a deficit requiring deficit repair contributions over and above the employer’s regular contributions.

A scheme in surplus does not face that risk but is still subject to exogenous risks from other sources. A company, or association of employers such as the USS, can become insolvent for reasons unconnected with its pension scheme. For example large numbers of students might start deciding that a university degree is not worth the cost and refuse to incur the level of debt required leading to universities becoming insolvent.

The assessment of the reliance on employers should separate out these two types of risk and treat them fundamentally differently in the analysis. The exogenous risks can be allowed for by adjusting discount rates for prudence according to the usual actuarial principles.

However the endogenous risks require recognition of the simultaneity between the liability valuation and the covenant. If the covenant is strong the scheme can remain open and invest in high return assets and ignore the short term volatility in their prices. Therefore the risk of not being able to pay the benefits is low. But if the covenant is regarded as weak there is a non-negligible risk of not being able to pay the benefits.

The reliance calculation that has been done by the USS is deeply flawed because it ignores this endogeneity of the liability with respect to the strength of the covenant. It uses a liability value calculation based on a low-risk investment portfolio, with a low – gilts-plus - discount rate, appropriate to a situation of weak covenant. This leads to a greatly exaggerated idea of the scale of risk and therefore biases the analysis against finding that employers can afford the scheme - provided it remains open indefinitely. The USS is in effect assuming what it is setting out to test: by using the ‘safe haven’ valuation for the self-sufficiency liability it is assuming the existence of risk that is a consequence of an assumption of a weak covenant, and then claiming it shows there is too much reliance. It is circular reasoning.

The calculation by the USS is incoherent because it fails to recognize that the liability depends on the assumed strength of the covenant. The self-sufficiency-as-safe-haven definition is appropriate for an assumption of a weak covenant where prudence requires the lowest risk investment strategy. But if the covenant is assumed strong, so that short run market volatility does not pose a serious threat, the scheme can remain open to new joiners indefinitely and implement an investment strategy accordingly. It can invest in assets like equities that have high expected returns since their greater price volatility does not pose risk to its survival.

The analysis of reliance by the USS does not establish what is being claimed for it.

References

Salt, Hilary and Derek Benstead, Progressing the valuation of the USS, Report for UCU, First Actuarial, 8 August 2017

USS, Proposed approach to the methodology for the 2017 actuarial valuation: response to the Valuation Discussion Forum, 22 November 2016.

USS, Draft 2017 Actuarial Valuation, 1 September 2017.



[1] Strictly the two hypotheses are non-nested with respect to each other. Neither is a special case of the other. The result of the tests may be indeterminate in that both are accepted or both rejected.(See for example https://core.ac.uk/download/pdf/7092823.pdf)

[2] This figure includes no allowance for prudence as required. However it is hard to believe it would not still be very large after such allowance was made.


June 25, 2018

Pensions: A sustainable social contract

Pension schemes are often described disparagingly – without evidence – as being unsustainable or unfair between generations, or even according to some people, a kind of fraud, a form of Ponzi scheme. That is because they are fundamentally intergenerational, in that pensions require the working generation to supply goods and services to the retired. That is inescapable and therefore all pensions are essentially pay-as-you-go in this sense.

This paper pensionssocialcontract.pdfcalculates the investment returns required for pension schemes on various assumptions and finds that if they are properly designed they are perfectly sustainable given the typical investment returns that are currently achievable.

It is important to note that the rate of interest on government bonds, ‘gilts’ – which are presently very low due to government policy known as ‘quantitative easing’ and such – is not the same as the rate of return on investments. Investment returns on equities and property are determined in the market and not related to government-policy driven interest rates.

The USS chief executive Bill Galvin has recently issued yet another statement in which he argues the opposite. He says that the cost of future accrual in the scheme is as much as 37.4 percent of salary. It is hard to accept such a high figure without a proper explanation. It would be good to know what lies behind it.


June 20, 2018

Too much money: It’s time to push back on DB deficits

Writing about web page https://secure.mallowstreet.com/Article/b33077

Here is the article that I linked to on twitter. It is behind a paywall which means most people could not read it, so I am posting it here. I have included the comments as well because they add something to the argument.

It is interesting in calling for reform of the way pension schemes are managed, especially regarding things like derisking. It is also calling for the DWP to take the matter on board and to act. The author, Robin Ellison, is a very much respected authority on pensions and what he says carries a lot of weight.


Too much money: It’s time to push back on DB deficits by Robin Ellison

For reasons which are probably obvious on the inside but seem impenetrable on the outside, the Pension Protection Fund continues to publish monthly stats on the collective deficits of UK defined benefit plans.

These numbers can fluctuate around £50bn in a month, which suggests that over 60 years any worries about collective UK private sector DB deficits are so volatile as to make publication of the numbers somewhat meaningless.

This over-statisticalisation of the system seems even less useful when looking at other studies which have been published in recent weeks. First Actuarial publish a frequent survey called FAB (First Actuarial Best Estimate Index), which suggests that at the end of April 2018, there was a collective surplus of £308bn and a funding ratio of around 125% on a best estimate basis.

The PPF itself, using a system in the course of refinement, suggests that schemes are collectively funded to around 95% on a s179 basis.

LCP coincidentally published their annual Accounting for Pensions survey in April, which showed that the FTSE 100 companies had a collective surplus (on an IAS 19 basis).

And even the defensive and increasingly aggressive Pensions Regulator has several times argued that the national funding issues for DB schemes were nothing to worry about – saying the system is in good shape.

Return to surpluses is possible

Of course, not much of this gets reported. But UK companies have been pumping funds into schemes over the past 10 years, and as interest rates stutteringly begin to firm, there emerges a non-remote possibility of a return to surpluses.

The question then will be posed by regulators, select committees and financial commentators as to what on earth we were doing to allow such a waste of capital to develop.

These counter-productive funding rules have impacted on British industry.


But not only has it resulted in over-provision; it has been coupled with a destructive ‘defensive investment’ strategy, investing through fixed income – especially index-linked and ordinary gilts – which will inevitably take a hit.

This policy has deprived many members of schemes from enjoying their expected pensions, and shareholders of their proper returns – all because of self-interested and counter-productive regulation and policy.

Time for the IFoA and PLSA to act

It is not too late. We now need to explain rather more forcefully than we have done so far, just what a fantastic job pension scheme trustees and their sponsors have done, despite the regulatory headwinds.

And it is time for (1) the Institute and Faculty of Actuaries to rethink just what is meant by derisking and (2) the PLSA to push back against TPR investment nostrums to try and live in what remains of the 21st century.

Because if we don’t, once the government has found post-Brexit time in its legislative timetable, we might regret not pushing back against the overzealous demands of the white paper as amended by the DWP select committee.

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Pauline Armitage19 June 2018 at 13:08
Excellent. No one listened last century so I doubt they'll heed the message now...but then there are 88 years to go so maybe.
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Peter Woolsey19 June 2018 at 13:35
At last someone with lengthy experience, and who knows probably more about the issues than anyone else, has bravely come out to challenge the establishment view and TPR on both deficits and funding principles. DB schemes last for generations (if allowed to do so!) and so funding and investment strategies must be based accordingly. De-risking merely demands more and more contributions from sponsors that quite possibly will not be required in the long term. There is potentially the danger that members' prospects of benefits at retirement will actually be harmed because of this. In the past, when investment was mainly in equity type vehicles, surpluses built up which would have served to guard against bad times; but Government got worried about the cost in tax relief and put a ceiling on funding levels. It's not surprising we got to the current position following this because all the good work in the past was undone by poor Government decision-making. It should be remembered that valuations are just a snapshot of a situation at a particular point in time.
Martin Veasey19 June 2018 at 15:04
Unless the covenant is in peril and there is a clear TP deficit, then it isn't a problem that a scheme is underfunded on a risk-free (or close to) basis - the liabilities aren't due today so why should one expect to have all the corresponding assets today? Yes, we should use this as a basis for longer term planning / aspiration but it's not a general emergency for the industry.Media reporting seems to promote the view that this is an immediate solvency metric and a general measure of health in the DB marketplace, both of which thoughts I disagree.

May 02, 2018

Being actuarial with the truth

(This blog post is for those who are interested in the technical aspects of the actuarial valuation. It shows that the criticisms of the valuation methodology many of us are making are well founded and supported by rigorous intellectual foundations.)


One of the best articles on pension valuation is this paper by Simon Carne that he presented to the actuarial profession in 2004, called "Being Actuarial with the Truth".

It is directly relevant to the controversy about how pension schemes are valued (for example see here) and especially the present USS issue. He shows the problems with attempting to value liabilities separately from assets and that the best way to value a scheme is to compare projected cash flows of income and outgo. The issue of the choice of discount rate then fades into the background.

There seems little reason not to follow his advice to form an overall view for practical management purposes alongside the regualtory requirements.

The paper also deals forthrightly with John Ralfe who is a very vocal critic of reported pension deficits. It shows that his analysis is fundamentally flawed. It is remarkable that he is still saying the same things - and getting media attention - today despite his arguments having been comprehensively rebutted in 2004!


April 30, 2018

The Joint Expert Panel will fail unless it is both radical and transparent

The agreement between the UUK and UCU provides that a “Joint Expert Panel, comprised of actuarial and academic experts nominated in equal numbers from both sides will be commissioned to deliver a report. Its task will be to agree key principles to underpin the future joint approach of UUK and UCU to the valuation of the USS fund.” If it is to achieve anything worthwhile it must carry out its task in a transparent manner.

The panel’s job will be to get at the truth against opposition from the vested interest of the USS executive who seem committed to a particular controversial view. The only way it can succeed in doing that is for it to proceed on the principles of free and open academic enquiry. Otherwise it will end up just rubber stamping what the USS is saying.

Let’s not forget that the scheme valuation according to the USS has not just been sprung on us. UUK and UCU, and their advisers and actuaries, have been discussing the draft valuation for months, if not years, since at least before the last valuation, for March 2014.

The UCU has been robustly challenging the methodology being followed by the USS, and many of its key assumptions. But it has been brushed off by Bill Galvin, the chief executive, and his executive team, without them seriously engaging with the arguments, while the Directors, in whose name they act, have remained silent, at least in public. It is to be hoped that some of them speak out against this one-sided approach, if only in board meetings.

If it is to do its job properly, the JEP needs to be radical, to address fundamental issues and ask basic questions. It is not enough just to hold a couple of meetings, listen to evidence behind closed doors and then issue its findings. It needs to transparently set out what its agenda will be in terms of “key principles to underpin the future joint approach of UUK and UCU to the valuation of the USS fund”. Only then, and if it openly publishes the detail of how it will do that, and is seen to subject the flawed USS approach to a radical re-appraisal backed up by evidence, will it satisfy members.


Issues for the JEP agenda


1. Accountability to members. The latest videos put out by the USS, featuring the CEO Bill Galvin, head of risk Guy Coughlan and scheme actuary Ali Tayyebi, fail to provide a satisfactory account of why changes are necessary and prompt questions about accountability. The Pension regulations state duties of a trustee in terms such as: “... ensure their pension scheme delivers good outcomes for members' retirement savings”; “Trustees must act in the best interests of the scheme’s beneficiaries”. It is arguable that the USS executive and trustees are falling short in their duty to the members.


2. Need to follow actuarial guidelines Actuarial guidelines say trustees “ ... must choose a method for calculating the scheme’s technical provisions, ie the value of benefits accrued to a particular date. You must take advice from the actuary on the differences between the methods and their impact on the scheme.”

The USS are not doing that because they are failing to properly consider different methods which give a different picture. This is not just of academic interest; there is a wide gap between what we are told by the USS executive and what makes sense to, for example, an intelligent person, whether a specialist such as an economist, statistician, or non-specialist, using a different method. They are doggedly working to a fixed blueprint and failing to consider alternatives which may benefit members.

The JEP should therefore insist that the USS executive be required to give a rounded view (ie taking into account analyses from different angles) of how the scheme is doing, and do so in simple language. They present only a single - relentlessly negative - view that clashes with the fact that the scheme is not in deficit in the ordinary sense of the word.


3. Need to explain the deficit. The overriding requirement is to require USS executive to explain how the present - apparently quite large - annual cash surplus of over a billion pounds per year turns into a deficit. Although this question has been asked many times by the UCU, so far no response has ever been forthcoming. Instead we just get a sort of financial hocuspocus. We need to know if there is really a deficit in a practical sense or it is merely a cconsequence of a particular theoretical approach lacking a sound empirical basis.


4. USS is a special case. The JEP should recognise that the USS is an extremely large scheme covering an important sector of the economy, one that provides vital public services. It is therefore unacceptable that it be managed solely according to a template intended for commercial company pension schemes. The scheme should be reviewed and valued in a manner that recognises the specific features of the pre-92 HE sector. It is not a typical company scheme and should not be compared with other DB schemes in a superficial or simplistic way (as the scheme actuary does in the video). Higher education should not be thought of as run in the same way as Woolworths.

5. Get power relations right. It is important that the JEP terms of reference have a proper regard to the power relations among the parties. The stakeholders are the UUK and UCU. The UUK institutions are the sponsors and therefore the senior partners. They ultimately call the shots. The USS board is accountable to the stakeholders, who appoint its members. They also employ the executive.

6. Role of the Pension Regulator. The regulator’s role, as a government body, is to ensure proper governance of pension schemes. It cannot and should not be taken as a substitute for the trustee and sponsor. The pensions regulation system is designed for (mostly small) schemes involving a single company in the market place. The university sector is quite different, and big and important enough not to be dominated by the regulator. Also it must be remembered that the pension regulations give trustees and sponsors wide discretion on many aspects of the valuation.
 The rules as not as strict as we are often told and the regulator uses its enforcement powers only reluctantly.


7. Strength of covenant. The JEP should thoroughly and seriously examine the strength of the employer covenant, that is the ability and capacity of the 300 plus employers, including 68 pre-92 institutions, collectively to support the scheme. The scheme should be seen as one covering a whole large and important sector of the economy, which is more resilient than the mere financial solvency of the current members of the USS. The activities of teaching and research that are the business of the members are not related solely to the existence of particular institutions, and the need for them will continue after an insolvency, requiring the continued support of a pension scheme.
 So it is wrong to look at covenant exclusively in terms of the solvency of individual institutions without considering the pre-92 sector as a whole.


8. Take a long-term view. Pensions are long-term commitments and funds ought to be invested on that basis. The valuation should also take a long-term view and ignore short-term fluctuations in asset prices. Short term market volatility is of minor, if any, relevance. Keeping the scheme open to new members is key. An open scheme with positive net cash flow can invest in assets that have a high expected return in the long run, such as equities. The efficient and rational running of the scheme suggests this.



9. The assessment of the covenant should beware circular reasoning. The discount rate used in the valuation reflects the strength of the covenant: where there is a weak covenant, prudence leads to a high liabilities figure based on a low-risk gilt rate being used as the discount rate. So it is circular to then use this liabilities figure in asking about the employers’ capacity to support the scheme, that is, whether the covenant is strong or weak. That is putting the cart before the horse: the assumption of a weak covenant leads to the conclusion that the covenant is weak.

Equally, basing the discount rate on an assumption of a strong covenant, giving the scheme freedom to invest in higher-return higher-risk assets for the long term, a higher discount rate and hence lower liabilities, might lead to the opposite conclusion. Assuming a strong covenant and valuing the liabiities on that basis might very well point to the employers being well able to afford to support the scheme indefinitely. The present covenant assessment method assumes the result it sets out to find and is not fit for purpose.



10. Further detailed questions. The JEP should require answers from the USS actuary and executive to questions of detail. It should not be satisfied with generalisations presented without evidence, which is their usual style.

Members should ask for further detailed information as follows: 


(a) Analysis of the scheme in terms of cash flow projections for income and outgo. Preliminary studies based on partial information done by First Actuarial have suggested strongly that the scheme is long-term sustainable over a range of assumptions. More work needs to be done, building on this, using the actual data from USS.



(b) Question the excessive use of index linked gilts (which are currently producing a negative return). The idea that investing in government bonds - following actuarial habit from a time when such assets provided a steady and safe return - should be questioned in light of today’s very low interest rates that result from government policy. It is highly irrational to invest in a way that guarantees losing money - money that will have to be found from higher contributions. The notion that such an investment strategy is a ‘safe harbour’ (as Guy Coughlan puts it) needs to be subjected to detailed scrutiny. Is the scheme actuary just following the customary practice, not noticing that its rationale no longer exists?


(c) Why not use the internal rate of return? Every pension scheme has an implicit internal rate of return required for its investments for it to be sustainable. It would cast a lot of light on the scheme and answer fundamental questions around sustainability if these could be provided and compared with actual and expected rates of return.


(d) Are investment returns in fact too low? The USS executive claim that expected investment returns have fallen too low for ‘most asset classes’. It is certainly true of gilts. But is it also true of higher income assets such as equities? The JEP needs to examine this argument carefully, because, even if expected returns have fallen, that may make little difference to affordability in practice - if discount rates are based on investment returns not gilts - especially if the scheme is in surplus.


(e) Investigate in detail the ‘best estimate’ valuation. The USS valuation document reports a ‘best estimate’ surplus of £5.1bn. Their statement that ‘the best estimate surplus has only a 50:50 chance of success’ need to be examined since it seem to be lacking in precise meaning. This 50:50 argument comes from the fact that the liabilities estimate is an average (median) over the distributon of investment-portfolio-return-based discount rates, but that in itself does not seem to tell us about the likelihood of the surplus not being achieved.


(f) Focus on the income from the investments not their price. This is a major issue that seems to be almost universally ignored in pension valuations. The fact is that the stock market and bond markets are much more volatile than the income that drives them - whether dividends or interest - well known from the work of e.g. Shiller and others. This excess volatility greatly amplifies risk if assets are valued at market prices. A true economic analysis would allow for this but it is being ignored by the USS executive. In an open scheme like USS it is income from investments that are important to pay the pensions and their asset prices are of minor importance.
 Valuing the scheme using asset market prices instead of investment earnings greatly amplifies risk. The JEP should commission an alternative valuation along these lines, with assets valued at discounted present value of expected future income.


(g) Question the facile assumption that equities are universally riskier than bonds. This assumption leads to statements being made with an undue degree of certainty and calculations done with spurious precision. Many equities provide good long-term investments without a lot of risk. Bond markets are also subject to short-term volatility like equity markets and there is excess volatility in both.



(h) Examine in detail projections of key parameters including mortality rates, salary growth, inflation, etc. Also the level of prudence.



USS Directors and their Remuneration

Many members are asking about the key decision makers who run the pension scheme. The trustee body comprises 12 directors, four appointed by the UUK, three appointed by UCU and five independents appointed by the board.

They are identified in the Annual Report and Accounts for 2017 p55 (pdf downloadable from here).

Their remuneration is set out in the table below. The UCU rules require that their appointed directors do not benefit financially and directors donate their fees to charity.

screen_shot_2018-04-27_at_131735.png



The remuneration of the USS Executive, the men who are in charge of day-to-day running of the fund and the pension scheme is not revealed individually. But their salaries are within this table.

executive pay

salaries


April 17, 2018

The advantages of an open pension scheme

Writing about web page USS; pensions

Many private sector pension schemes have been closed to new members and to future accrual by existing members. The University Superannuation Scheme is just the latest in a long line of company schemes to have done so, to the detriment both of their members and to other employees who have been offered much inferior defined contribution schemes.

Here the UCU's actuarial advisers, Hilary Salt and Derek Benstead, make the case for keeping a scheme like the USS open.


We start by reviewing the advantages of an open, trust based
pension scheme. The Universities Superannuation Scheme is a
defined benefit scheme open to new members. It is sponsored by
several hundred employers, and covenant advice ... shows a
“uniquely robust”, “strong” aggregate covenant.


Being an open scheme brings significant investment advantages,
which can be exploited to the benefit of the employers and
members. The investment time horizon is infinitely long. An open
scheme pays its benefits from contribution and asset income
without any need to sell investments. If the asset income is
sufficient, fluctuations of their market value is relatively unimportant.
An actuarial model of a continuing scheme which displays
vulnerability to market value fluctuation can be questioned as to
whether it is representative.


Few other investors have such a long investment time horizon.
Consequently, the expected return on investments of more certain
income and market value is low, because of the weight of investors
in such assets. The cost of providing benefits from investments of
low return is high, leading to undesirable increases in the
employers’ contribution rate, or benefit cuts, or both in some
combination.

An open pension scheme with time on its hands can
afford to invest in assets of uncertain return, because these assets
have a higher expected return, short term market value fluctuation
is relatively unimportant to the scheme and the scheme can wait for
however long it takes for the return to emerge. The principal
determinants of long run return are the rate of income and the rate
of growth of income.


Over the last 20 years, the experience of pension schemes which
close to new entrants and reduce benefit accrual or close
altogether, is of ever increasing costs. The consequence of closing
to new entrants and to accrual is to shorten the investment time
horizon from infinity to, eventually, zero. The scheme moves into
net negative cash flow, which requires investment in cash and short
term bonds to meet net outgo without reliance on the forced
disinvestment of other assets. The act of closure pushes the
scheme into an increased need to invest in cash and bonds, which
have low expected returns, which pushes up the employer’s
contributions.


Closure of a pension scheme is often justified on grounds of the
need to control cost. The experience of schemes is that closure has
had the opposite effect: it increases the need to invest in bonds and
cash (and LDI and annuities) regardless of cost. The bond market
has been rising continuously for over 20 years, and the cost of
closure has been very great.


The lesson to be learned from closed schemes is not to mimic
their funding and investment approach, but to avoid it. It is better to
retain the investment advantages of an open scheme and exploit
them to the benefit of the employer’s contribution rate and the
members’ benefits. The USS, with its good aggregate employer
covenant, is in an ideal position to do this.

(From Progressing the Valuation of the USS, First Actuarial report for the UCU, 8 August 2017)


April 07, 2018

Very misleading THE article comparing DB with DC pensions

An article about the USS pensions dispute in the Times Higher Education by David Voas (Let's defend pensions not defined benefits) gives a somewhat inaccurate account of the issue. It also makes a comparison between Defined Benefit and Defined Contribution pensions that is very misleading.

At the centre of the issue between the union and the employers is what kind of scheme it is. The employers want to end the guaranteed pension that is based on years of service and earnings, and replace it with a defined contribution arrangement where instead of a pension on retirement one gets a pot of money that depends only on what has been paid in and investment returns.

The article argues compares a young person aged 30 near the start of their career with someone nearing retirement, and concludes that the youngster would do a lot better under Defined Contribution. This is very misleading. For most people (almost all in fact) they would get a lot better penson in retirement from a Defined Benefit scheme.

The article actually makes a number of statements that are wide of the mark. And it is not sufficiently analytical.

For example it says, "defined benefit schemes are defunct unless underwritten by the taxpayer." That is not really true. There are schemes in the private sector that are not defunct. And there is no reason why the USS should be defunct without taxpayer support. The problem is with the way the regulations are being applied and the weakness of the employers. While it is true that most of the DB pensions schemes are in the public sector, such as the Teachers Pension Scheme that is normal in the post-92 universities, what Voas is getting at, I think, is a repetition of City group think that applies simplistic generalities.

His description of the problem, though, goes from vagueness to missing the whole point. He writes,"The problem is twofold. Employers struggle to afford the cost of guaranteeing that the benefits promised in 50 years' time will be paid ... Employees are also hit, though, because everyone ends up paying above the odds." (emphasis added) What does this mean? It sounds very bad. It is not factually true. There is no conclusive evidence that employers struggle to pay the pensions in 50 years. All that is required is that the scheme stays open until then and invests in high return assets such as company shares (equities).

The next paragraph is an explaination but is in fact a gross oversimplification to the point of being misleading, revealing that Voas has not understood the arguments: "The basic equation is simple enough: contributions plus investment income equals benefits. Contributions - and even benefits - are fairly predictable, albeit affected by changes in life expectancy. The challenge is to estimate real returns on investment over several decades."

That is not where the problem lies. There would actually be no problem if it were as Voas says. The USS investment portfolio has a high return, an average of 12 percent per year over the past five years, for example, and is expected to continue to do well into the future, since it is skewed towards equities.

The problem is that the liabilities (present value of future benefits) are being valued counterfactually. That is, NOT using the real returns on investments as described. If things were as Voas says, there would not likely be a problem. The problem is that the scheme is being told to assume very poor returns - index linked gilts have a negative return. So the problem is a result of the excessive prudence being forced on the scheme by the regulations and the weakness of the support from the employers.

In order to compare DB with DC, he contrasts two academics with the same salary, a woman aged 30 with an older man nearing retirement. They both receive a defined benefit of 1/75 of salary for a year's work. He claims that for the older man it is a windfall: "he receives substantilly more than his current contribution would support. For the 30 year old it is very poor value. She could conservatively expect her contributions to grow by 2 per cent per annum, thereby doubling her money by age 65. This fund would be worth more than the defined benefits." This is very difficult to make sense of. Why compare these two individuals in this way, by just taking a snapshot of one year. What pension would the young woman get when she retires? How would that compare with the man? Surely what is needed is to compare the pensions obtainable from DB and DC over a whole career, not just one year taken at different stages in life. It is also very superficial. We are not told if the returns are after inflation. All defined benefits are uprated for inflation by the CPI.

And so it goes on. It reads as if the article were simply intended to make the case for DC over DB. But that goes against all the evidence from academic studies and practical knowledge from actuaries. It also goes against the studies that have been done for the UCU by its actuarial advisers, which show that for the great majority of members, it is very considerably more expensive to provide a pension of a given annual amount by DC. Estimates have put this at between 40 percent and 100 percent more.

This piece is extremely poor scholarship.


Observations from a City expert on the USS proposals: Why Change?

These comments on the USS proposals have been written by John Murray, who is neither an academic nor a member of USS, but has an expert understanding of the issues, having over fifty years of experience in the insurance industry.

A sustained large-scale academic assault on decades of mistaken focus on point-in-time market values and inappropriate discount rates may yield results that strike action cannot.’
(Extract from a letter published in the Financial Times on the 13th March 2018 on the subject of the USS dispute.)

His comments below relate to two recent documents provided by USS Managers, entitled ‘2017 Actuarial Valuation’ dated 1st September 2017 and ‘31 March 2017 Actuarial Valuation’ dated 8th December 2017

Summary

On the deficit

While the derivation of the discount rate applied is far from clear it does appear as though the apparent shortfall results from the managers’ deliberate intention to shift the fund’s investment portfolio to low-yielding government securities. Without this change there would be no deficit.

On ‘De-Risking’ and Collateral Damage

‘De-risking’ appears to consist of changing the investment profile as described above and then back-filling the resultant shortfall by use of the employers’ current deficit contributions of 2.1% of pensionable salaries. The consequent closure of what remains of the ongoing DB scheme seems to be regarded as collateral damage.

On Risk Generally

  • Referring to long term investment in equities as ‘betting’ or ‘gambling’ is inflammatory, ill-advised and has no place in a discussion of this nature
  • Investing in government securities is by no means risk free
  • Nowhere is the risk inherent in the opportunity cost of missing out on potential equity returns addressed
  • The risk that members may be deprived unnecessarily of a valuable benefit by reason of the adoption of a low-yield investment policy is never even mentioned
  • The only risk that the managers seem to be interested in avoiding is the risk of a problem with the Regulator.

On ‘Self-Sufficiency’

‘It would be difficult to convince the man on the Clapham Omnibus that one achieves self-sufficiency by reducing the income available to the fund’

On Achieving the Stated Objectives

On no common understanding of the terms will the managers’ proposed action achieve the stated objectives of de-risking and securing self-sufficiency.

On the Way Forward

  • The direction being proposed by the managers needs to be abandoned
  • USS is uniquely placed to seek a derogation from the much-criticised pension rules
  • A joint case to make an exception should be put forward by UUK, USS and UCU

Observations on USS Proposals as set out in two documents entitled ‘2017 Actuarial Valuation’ dated 1st September 2017 and ‘31 March 2017 Actuarial Valuation’ dated 8th December 2017

In the notes that follow, the above documents are identified as 9/17 and 12/17 respectively. The latter document is to some extent an update of the former but is much less extensive.

1. Summary and Overview
1.1. Although neither of these papers is presented as a set of proposals for action, but rather as a review of certain suggested valuation assumptions, they very clearly contain implicit proposals that involve a radical restructuring of the USS (the Scheme)’s investment portfolio.
1.2. Boiled down to their essentials, the proposals are aimed (perhaps not directly but certainly effectively) at reducing the investment income that the Scheme will receive in the future, thereby creating a funding deficit. One of the consequences of this action will be the need to remove what remains of the final salary scheme going forward.
1.3. The reasons for this action are given as either ‘de-risking’ or creating ‘self sufficiency’. These notes will argue that the proposed action will achieve neither of these objectives while unnecessarily depriving members of what is left of a valuable benefit.
1.4. These notes also include suggested possible ways out of the current predicament.

2. Introduction
2.1. The Scheme’s financial position is set out below:

USS Funding Position – Gap Analysis
Source: 31 March 2017 Actuarial Valuation dated 8 December 2017
(£bn)

Best Estimate Approved Basis Gap

Accrued Liability 54.8 67.5 12.7
Assets 60.0 60.0
Surplus/Deficit 5.2 -7.5 -12.7

Self-sufficiency 82.4 82.4 0

Mean discount rate
(above gilt yield) 2.31% 1.20% -1.11 (-48%)

2.2 The expression ‘Best Estimate’ in the first column should not be confused with the business term ‘Best Case’. In the Definitions at p 57 of 9/12 ‘Best Estimate’ is defined as ‘The trustees’ unbiased view of the future outcome for different variables without adjustment [or] with margins of any kind. It is consistent with the median (or 50thpercentile) outcome’. This might fairly be translated as business ‘Mid Case’. Moreover, the definition of ‘Discount Rate’ in the same glossary says ‘The discount rate for technical provisions is determined by the expected investment return less a margin for prudence’, so it may be expected that this mid case outcome does in fact contain some element of caution.

2.3 The term ‘Approved Basis’ might be better described as ‘Managers’ Selected Basis’. The deficit that appears in this column is the result of the lower discount rate employed. But this column should not be confused with ‘Worst Case’. It is not an attempt to see what will happen if the margin above the gilt yield happens to drop by 48%. What it represents is the expected deficit that will result from changing the approach in line with the comments made in the body of the documents. In other words the deficit does not come about as the result of some possible economic downturn but as the direct result of action that the trustees are, by implication, choosing to take. The actual discount rate is not made explicit but is expressed as a margin over the gilt yield. There are several sets of numbers given in the documents but again the mean rate is never made clear. The nearest clue is at p 10 (12/17) where, under the general heading of ‘Investment Return (discount rate)’ it says that ‘This approach therefore includes a provision for a gradual investment de-risking [i.e. moving to gilts or equivalent] to take place over years 1 to 20’. As far as it is possible to tell, this seems to explain the movement in the mean discount rate between the ‘Best Estimate’ and ‘Approved Basis’. The deficit would not, therefore, be expected to arise if things were to remain as they are.

2.4 The expected rates of return on different types of investment presently in use are set out below. The effect of the proposals, basically to shift from equities to gilts, can be clearly seen.

Projected Real Rates of Return (i.e. adjusted for inflation)
Source: 31 March 2017 Actuarial Valuation dated 8 December 2017

Asset Class 30yr Expected

Equities 3.64%
Property 3.23%
Listed Credit 1.45%
Index Linked [Gilts] -0.76%
Cash -0.56%

3. Why the Change?

3.1. The reasons given are described as ‘de-risking’ or seeking to achieve ‘self sufficiency’. The two concepts, as used in the reference documents, are closely interrelated. Self-sufficiency is described at p 58 (9/17) as ‘The value of assets that are required to meet the Scheme’s accrued defined benefit liabilities while adopting a low risk strategy. By a low risk investment strategy we mean one for which there is a low probability of ever requiring additional employer contributions to fund benefits accrued to date.’ Note that this does not include benefits that might be accrued in the future.

3.2. One might well ask why it is thought that self-sufficiency is best achieved by moving to a class of assets that has traditionally produced such a poor return. And also if it is correct to describe gilts as ‘low risk’. These matters are addressed at 4 and 6.

3.3. It is safe to say, however, that this notion (shifting to gilts or similar) runs throughout both documents as though it was a given. Sometimes it is denied, for example at p 43 (9/17) it says ‘The trustees apply a ‘discount rate’ to the liabilities which is based on assumed returns from current and planned future asset allocations. This does not adopt a formulaic approach to setting the discount rate linked to gilt yields’. But at pp 49 & 50 of the same document it says ‘For the ‘self-sufficiency’ and ‘economic’ bases the discount rate assumes a term structure derived from the yield of fixed interest gilts appropriate to the date of each future cash flow (extrapolated for cash flows beyond the longest available gilts) as advised by the Scheme Actuary. For the ‘self-sufficiency’ basis a margin of 0.75% is added’. So practice would seem to differ from theory.

3.4. The real reason for the proposed change is never articulated but it is not too difficult to divine. The objective of the Scheme managers is to switch the investments to what at p 28 (9/17) are referred to as ‘bond like’ investments aimed at producing the gilt yield plus 0.75%, and then to fund the resulting deficit by use of the (employers’) ‘current deficit contribution of 2.1% of pensionable salaries’. This deficit, it is estimated, will be eliminated in eight years (pp 24&25 9/17). After that they hope that the income from the ‘bond like’ investments will be sufficient to ensure that the employers will not need to shoulder any further increase in their contribution.

3.5. It is, of course, inevitable that defined benefits arrangements are discontinued at this stage otherwise, with such a poorly performing investment portfolio, the contributions required to keep these benefits going would be enormous.

3.6. There is a driver behind the driver and that is current pensions legislation which pushes schemes down the gilts route. The essentially flawed thinking behind this legislation is considered at 4 and 7. It is in this area that the real battle lies (see 7.2) and it would be valuable if the trustees could be brought on board. The managers’ intention is to reach some notional ‘safe haven’ whereby if things do go wrong they have assured the trustees that they will be free from any liability because they have followed the ‘safe’ route. This should secure a quiet life for all (except the Scheme members).

4. Investment, Gambling and Risk

4.1. Before moving on to consider a way out of this morass, it would be opportune to take some arguments off the table before they are employed as a counter. It is sometimes contended, for example, that investing in equities constitutes gambling and that using this form of investment is equivalent to ‘betting’ the scheme’s funds on the vagaries of the stock market. As we will see below, there is risk inherent in all types of investment but it is important to differentiate buying equities to hold for the long term and buying and selling in short order with a view to a quick profit: the former is investing and the latter may be considered a form of gambling (like the activities of a day trader). Moreover it is worth bearing in mind that equities, as a class of investment, have outperformed all other forms of investment, including UK house prices, over the long term (and what is a pension fund if not a long-term investment?) or at least in the period from 1900 to end 2017. See Global Investment Returns Yearbook: Credit Suisse (publ.). Talk of gambling or betting is inflammatory, ill-informed and inappropriate in this type of discussion.

4.2. Government bonds, on the other hand, are by no means risk-free investments as is sometimes claimed. Some of the risks involved are implicitly acknowledged in the reference documents but it would be as well to make them all explicit here.

4.2.1.Matching Term Risk
This is acknowledged by implication on p 10 (9/17) where it refers to ‘...cash flow (extrapolated beyond the longest available gilts)...’ Pension funds are very long–term undertakings whereas government bonds have end dates and it is often impossible to match the pension terms with government securities. This risk does not exist with equities.

4.2.2 Assumed Future Interest Rates Risk
There is an assumption by the managers that [bond like] rates will revert to ‘normal’ in ten year’s time (see the jump in the discount rate at year 11 in the table on p 51(9/17) and also p 5 (12/17). At p 8 of document 9/17 it is observed that ‘If interest rates do not in fact revert as forecast to the levels proposed (sic) by the trustees, then future contribution requirements could increase…...’ Well, yes and maybe a stronger word than ‘could’ would be appropriate. This risk is a heavy one and could be avoided. They got it wrong in 2014 when they thought that rates would have reverted by 2017. See p 9 (9/17) ‘Between valuations, long-dated index-linked gilt yields have fallen from already historically low levels by a further 1.5%, making them more expensive than in 2014. As a result the trustees could not de-risk the portfolio under the funding triggers agreed at the 2014 valuation’.

4.1.3 Reinvestment Risk
Because government securities are issued for a fixed period, they are automatically redeemed when the period ends. It is by no means certain that a similar rate of return will be available on issues then coming onto the market. See the remarks about extrapolation of cash flows under Matching Term Risk

4.1.4 Pro-Cyclicality/Availability Risk
If everyone is seeking to invest in bonds then this will drive the prices up and the returns down. This is implicitly acknowledged at p 9 (9/17) also see under ‘Assumed Future Interest Rate Risk’ (above). No mention is made of the fact that, if the government is looking to reduce the level of its borrowing, there is the risk that there may not always be sufficient bonds issued to meet demand. This is already a factor in Germany.

4.1.5 Sovereign Default/Concentration Risk
While the British Government has never so far defaulted on a bond, sovereign default is not unheard of and the future is difficult to predict. Going almost exclusively for government bonds introduces a risk concentration element which does not exist with a well diversified portfolio of equities

5 The Risk that Durst Not Speak its Name

There is a very significant risk that is not even alluded to in either of the reference documents, namely that the members may be deprived of what remains of a most valuable benefit for no good reason. Future history could well show that by maintaining a portfolio of mainly diversified equities sufficient income would have been produced to keep current benefits in place. This is the clear implication of the ‘Best Estimate’ valuation. Trustees owe a duty to every participant and not just the Regulator (as one could be forgiven for imagining reading the reference documents).

6 De- risking and Self-Sufficiency

6.1 So far as concerns the question of removing risk it is difficult to see how the proposals will achieve this, unless one regards equity investments as inherently so very risky that they must be avoided at all costs. But as has been demonstrated above, there are many risks associated with government bonds and it could be argued that the real risk that the planned action will run is the opportunity cost of not investing in equities and so missing out on the returns that have traditionally been available from this source. The only risk that the managers seem to be intent on avoiding is the risk of possible problems with the Regulator.

6.2 It would be difficult to convince the man on the Clapham omnibus that one achieves self-sufficiency by reducing the income available to the fund. It is only the very strange definition of self sufficiency contained in the document (first create a deficit and then seek to back-fill it) that will be secured by the proposed approach.

6.3 There is a powerful argument to say that what is being proposed will achieve neither the reduction of risk nor any degree of self-sufficiency.

7 A Way Forward

7.1 As has been demonstrated above, the proposed approach fails in its objectives and, by way of collateral damage, ends defined benefits going forward. It would be wise, therefore, to abandon ‘de-risking’ and revert to a more balanced portfolio of investments, including a substantial equity element. This will not be so easy to achieve, however. As explained at 3.4 to 3.6 (above) there are regulatory issues to consider. It is most probable that the managers will have intimidated the trustees and convinced them of the absolute necessity of reaching ‘safe haven’ if they are to be sure of avoiding any risk of personal liability. It would not be the first time that such a thing has occurred and the natural caution of the trustees is understandable in the circumstances. Further, the Regulator may be expected to support the managers’ position. The Regulator’s role is to enforce the rules, not to consider the best interests of the scheme members.

7.2 The easiest way to arrest the planned journey to Armageddon would be to seek a
derogation for the Scheme. There are grounds for this. At pp 35 et seq. (9/17) reference is made to the strength of the employers’ covenant. The heading at 1 on p 35 states that ‘The covenant is uniquely robust’ and at 2 that it is ‘........rated as ‘strong [the highest rating] by PwC’. For all the reasons explained in the document this looks to be a fair assessment. One could therefore argue that the Scheme, in its unique circumstances, should be allowed to derogate from the real or implied rules of pensions legislation and to continue with a (truly) balanced portfolio approach. It follows that the trustees should at the same time be granted immunity for any adverse outturn that might follow the granting of this derogation.

7.3 There is already support for this view. In a letter published in the Financial Times on 13thMarch of this year and referring directly to the USS, the joint signatories called for ‘A sustained large-scale academic assault on decades of regulators’ mistaken focus on point-in-time market values and inappropriate discount rates…’ And it should be emphasised that the requested derogation would cost the taxpayers nothing. To have the maximum chance of success the application should be made jointly by UUK, the Trustees and the UCU to the Pensions Minister.

7.4 Another, though less certain, approach would be to see if the trustees could avail themselves of what is known as ‘the business judgement rule’ which is available to members of company boards. This says effectively that directors cannot be held liable to their shareholders for an adverse business outcome if they made the decision in good faith. This can apply even to contrarian decisions such as assuming a rise in oil prices when, in fact, they fall. Broadly the claimant, to have a chance of success, needs to be able to show that the directors acted in their own interests and against the interests of the shareholders or favoured one group of shareholders over another. It is a powerful defence and it might be worth finding out if the trustees could take advantage of it or something similar. If the current advisers still insist on the proposed course of action then it should be possible to find some advisers who will take a different view. After all the shortcomings of the current pension rules and their consequences are well known.


Badly designed regulation causing pension schemes to fail

Government regulations for defined benefit pension schemes, as they stand at present, under the Pensions Act 2004, are a major factor contributing to the pensions crisis that has seen the closure of scheme after scheme.

The problem stems from the rule requiring schemes to be judged on a simple comparison of market-based capitalized values of assets and liabilities every time there is a valuation, every three years. This rule is misguided for two reasons: because it is arbitrary in that it does not provide a meaningful comparison; and because it greatly magnifies risk, costing a lot of money to offset.

The rule is arbitrary because of the inconsistent way it requires assets and liabilities to be compared. The assets must be valued at market prices on the valuation date. But the value of liabilities, which is not priced in a market, must be estimated as some kind of present value of the pension promises. Since pensions consist of a stream of payments to retirees for many years into the future, there is no asset that can be traded in a market, and the regulations do not prescribe precisely how calculation should be done. The liabilities value is therefore essentially a notional sum.

The two sides of the balance sheet are calculated using very different methods. I will discuss the problems with the assets side later but first consider the liabilities figure. This is meant to be an amount of capital today that would, if invested, yield just enough to pay the pension benefits.

This thought experiment is a matter left to the trustees, with general guidance from the regulations and actuarial advice. They must decide whether – hypothetically – to invest in ‘safe’ bonds or ‘risky’ equities and other growth assets, or a mixture, subject only to the need for having regard to prudence. A sensible choice – you might think – would be to use the actual asset portfolio they have invested in. That would be consistent. However they often find themselves under great pressure from professional advice not to do that but to assume a ‘risk-free rate’ such as the return on long term gilts. Accountants would probably say it is mandated by FRS102. (By the way, even if they switched their portfolio into government bonds it would not be risk free.)

Thus, assets and liabilities are constructed using different – inconsistent – methodologies, making the difference between them – the ‘deficit’ or ‘surplus’ pretty arbitrary. A scheme that is open to accrual can be in ‘deficit’ even though it may have positive net cash flow and is not having to sell capital: in other words it is not in deficit in the way we usually understand the word. That a scheme is in ‘deficit’ is often – usually – reported as a bald fact without a proper health warning.

A notable example that is attracting a lot of ill-informed comment is the country’s largest funded scheme, the scheme for the older or pre-92 universities, the USS; the employees’ union, the UCU, is making my point but the USS executive show little sign that they are willing to listen. However the employers’ body, the UUK, have said they are willing to look at it in a joint experts’ panel with the union.

When a scheme is in notional deficit – as most currently are because near-zero gilt rates have blown up the liabilities – the regulator requires employers to make recovery payments. For an open scheme this often presents an existential threat if the employer cannot afford the payments.

Clearly, the valuation of liabilities is a serious problem which means that deficits or surpluses are arbitrary. Since they are the difference between two large and imprecise numbers they are also very volatile.

But things get much worse when we consider what the valuation of the assets means.

The regulations require assets to be valued at market prices. But, if the scheme is open, asset prices are the wrong indicator because pensions are paid out of earnings. In theory this should not matter because asset prices should exactly reflect the underlying earnings in dividends, rents, interest and so on. But markets are not perfect – in fact far from it – and this equivalence does not hold in practice.

This point is widely ignored by financial economists, even though it is well known to economists. Studies by the Yale economist Robert Shiller and others, have compared asset prices with their theoretical values based on discounted future earnings, and found them to be massively too volatile in practice. Equity prices, for example, are known to be many times more volatile than the economic fundamentals, that is, expected dividends, would suggest. The same is true of bonds and real estate.

It cannot be stressed enough that excess volatility is large. For example, in his book “Irrational Exuberance”, Shiller reports that “only 27 percent of annual return volatility of the US stock market might be justified in terms of genuine information about future dividends”. This would imply excess volatility of equity market prices by a factor of around four.

This does not matter much for a closed scheme where the assets must be enough to cover the liabilities whatever discount rate is used. The focus is on aligning finite assets and liabilities. Market valuations are inescapable.

But it matters a lot for an open scheme that holds its investments long term for income. Rather than at market prices, assets should be valued as the capitalized value of projected future expected earnings, using the same discount rate as for liabilities. This is much less volatile than asset prices.

But the regulations insist on using asset prices, with the result that volatility – which otherwise would be inessential to an open scheme – must be treated as a source of risk. The regulations therefore pose a major threat to an otherwise healthy and sustainable scheme because the notional ‘deficit’ will need to include an allowance to cover the risk due to excess volatility. Yet this market volatility is irrelevant to the financing of the scheme on an ongoing basis.

The regulations are intended to protect accrued pensions benefits against company sponsor failure. But there is two-way causation and schemes may close because the cost to the employer of plugging ‘deficits’ is too high. This has been a major factor in schemes closing. If deficits are over-stated because the rules treat market volatility as risk, then the rules themselves are unfit for purpose.

This therefore suggests two recommendations for reform. First, value an open scheme on an ongoing basis, rather than using market asset prices, which is an implicit assumption it is about to close. Rather than comparing market-priced assets against capitalized liabilities, trustees would get a better picture by comparing the profile of projected income and outgo. That would avoid both the arbitrary choice of a discount rate and the increased risk due to excess volatility of market prices. This reform would remove the reverse causality of an artificial deficit undermining the covenant. There still remains risk of the loss of employer support.

The second reform would deal with that risk. The Pension Protection Fund should protect open schemes as well as closed ones. A pension scheme does not have to close on employer bankruptcy if the work of the employee members continues with or without another employer sponsor. In extremis the PPF could act as sponsor. As a statutory body the PPF can afford to be a patient investor, investing for the long term to gain the equity premium. This means that the a scheme transferred to the PPF would have a lower deficit or surplus when valued as above.

The PPF will be able to support open schemes as well as closed ones. This would reduce the pressure on open schemes to close. The PPF should become a real safety net enabling companies to take a long view of their open schemes, thereby saving them having to make provision for short run market volatility as risk, reducing the cost of pensions. A consequence of this will be greater confidence in DB schemes many fewer scheme closures.


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