All entries for November 2014
November 27, 2014
Warwick University yesterday published its comments on the UUK consultatoin on the USS 'technical assumptions'. The report, written by a subcommittee of lay members who are not USS members, has been approved by the university's governing Council, and will go forward as part of the University's response.
It is highly technical but constitutes a powerful critique of many of the assumptions made by the trustees and effectively a rejection of their case for scheme changes. Certainly it undermines the idea that radical changes are needed to meet a yawning deficit. It also supports the alternative approach to valuation proposed by the UCU (see the appendix to the letter by Sally Hunt to the trustees on 8 September).
In carefully measured language and closely reasoned argument it delivers a damning verdict:
...the need to achieve a decisive outcome for future funding arrangements needs to be balanced against making irreversible changes to benefits which may go further than is necessary if the deficit, as we argue in this report, is based on over-pessimistic assumptions and inappropriate methodology."
It shows that using less pessmistic, more realistic assumptions and more appropriate methodology there might not even be a deficit at all.
We show that by adopting in some cases marginaly different assumptions from those used by the USS trustee but still within the bounds of acceptable prudence, the combined effect of the changes in assumptions is that the estimated deficit of £12.3bn is reduced to £1.36bn. We note that if the future service salary scale is applied for past service benefits, the estimated deficit could be turned into a surplus of £440 million."
Some other quotes from the report:
We believe that the initial discount rate is overly pessimistic."
Whilst we are not opposed to the principle of de-risking when market conditions are conducive, we feel that the proposed approach is over prudent and will only serve to “lock in” the current deficit."
We argue that the result of a questionable deficit of £12.3 billion drives some of the proposed changes in benefits that we thihk should be reconsidered. The size of the estimated deficit is also likely to result in the premature de-risking of the investment strategy. This in effect means that the estimated deficit will tend to become a reality, in other words a self-fulfilling prophecy."
We believe that a general inflation assumption for salaries of RPI plus 1% is overly
... there is now a considerable body of opinion that the improvements in longevity seen the last three decades will not continue. In any event, we believe that 1.5% is too pessimistic and that the Office for National Statistics’ projection of 1.25% is an appropriately prudent number to use."
Given current rates of inflation and the increasing concern about the possibility of deflation in a number of major western economies, we believe [the assumed rate of future RPI inflation] is too high even for long term purposes."
That the breaking of the final salary link for accrued benefits should not be pursued."
That the £50,000 threshold for the CRB section be removed if the financial impact of
doing so is acceptable to employers. Should this prove unacceptable then the CRB
threshold be increased to spine point 51."
That if the scheme’s funds’ investment performance results in a surplus that might
reasonably be expected to be maintained in the future, consideration should be given at
that point to appropriate improvements in benefits and/or reductions in contributions.
Even if not all of our proposals for changing the assumptions are accepted, the results above clearly demonstrate how highly sensitive the valuatoin methodology is to relatively small changes to the assumptions. The 2014 valuation is a transient exercise in circumstances where the assumptions as originally proposed, given the consistnetly conservative position taken, could change significantly by the time we get to the next triennial valuation in 2017. The impact on members' pensions is likely to be irreversible."
Our overall view is that collectively the assumptions are over-prudent and consequently we believe the scale of the resulting deficit to be materially pessimistic.
November 26, 2014
Imperial College London have now publicly opposed the UUK proposals for changes to the USS. They say firmly:
We are concerned that ... you risk recommending a major downgrading of one of our employees’ most important benefits based on numbers which are as likely to be modelling artefacts as a reflection of the underlying economic reality.
See the full statement at
November 24, 2014
A group of leading authorities on statistics, financial mathematics and actuarial science have written to Sir Martin Harris, the chairman of the USS trustees, and members of the board, criticising the assumptions that have been made underpinning the estimation of the deficit, as detailed in the document 'USS: 2014 Actuarial Valuation: A Consultation on the proposed assumptions...'
They point out that some key assumptions the trustees have made, that underlie the calculations that produce a figure for the deficit of over £12 billion, are unrealistic and in fact unnecessarily pessimistic. In particular they criticise the trustees for assuming:
- pessimistic investment performance based on gilts rather than the actual experience of the USS investment portfolio,
- a far too high rate of price inflation,
- a rate of salary growth above what has been achieved in the past,
- an increase in the rate of increase of longevity without supporting data (indeed the latest actuarial estimates report a reduction in expected lifespans),
- too short a time horizon for the employer covenant (one more appropriate to a private company than the university sector).
They also make some fundamental criticisms resulting from the methodology being used:
- There is an element of circularity in the reasoning - much of the deficit is due to the expectation of poor returns in the future (because of the gilts-based approach) and the short 20-year time horizon for the employere covenant - which in turn is said to be necessary because of the unwillingness of employers to pay high contributons due to the deficit.
- The assumptions are chosen in a manner which is economically incoherent - buoyant salary growth assumes a strongly growing economy while poor investment returns assume an economy permanently in recession - both these assumptions serve to inflate the deficit.
- All the assumptions made assume a 'worst case' scenario. The combined effect is to be unduly pessimistic.
- The estimates obtained by the trustees' approach exhibit wild swings, with rapid instability over a period of months in the estimated liabilities, while the real liabilities are known to vary very slowly on a decadal beasis.
...moving to evidence‐based assumptions on salary growth and RPI would show the scheme to be in healthy surplus on a neutral assumptions basis. Remove the derisking assumptions and that surplus would be substantial. Substitute historic asset growth performance for Gilts plus and the neutral basis would show a very substantial surplus.
November 21, 2014
The UUK proposal to end final salary pensions for existing members is a very radical move that will effectively breach the contract that staff entered into when they started their careers: the entitlement to a pension that is a decent and predictable fraction of their earnings when they retire.
Even though the Hutton report into public sector pensions recommended moving defined benefit pension schemes over to the career average principle, it was clear that was a long-term aim and should not be applied retrospectively to exisitng members. It said: "Maintaining the link to final salary for the purposes of calculating the value of a person’s accrued rights under the existing schemes will however ensure fair treatment for those who have built up rights in these schemes..."
What the UUK proposed originally is that members of the final salary (FS) section of the USS should be moved to the CRB section for future accrual after the changeover date (proposed I think April 2016). Their salary at that point - instead of their final salary at reitrement - would be used as the basis of the pension. Their service would be counted against that salary. For example someone with 20 years' service would get a pension of 20/80 times their salary in 2016. This would then be uprated for inflation based on the consumer price index during the years until retirement. This is unfair as Hutton says. This has not happened with the changes in the Teachers Pension Scheme which is continuing to honour the final salary principle for existing members although new members are in the CRB section.
It is also unfair in another sense: that it is making members pay with their pensions for one of the consequences of university privatisation, a coalition government policy motivated solely by ideological dogma that they do not benefit from, and for which there was no democratic mandate.
This is clear from the UUK document "UUK's proposals for modifications to the USS benefits" submitted to the USS JNC (circulated as an appendix to UCUHE234.pdf, circulated to UCU branch officers on 27 October 2014) in which the reduction in liability that results from removing the final salary link to past service is to be used to offset the additional deficit from 'de-risking' due to privatisation.
Ending the final salary link to past service for existing members is calculated to save £6 billion. That is almost the same as the increase in the deficit that is due to de-risking.
But the policy of de-risking is a choice that the trustees are making as a result of structural changes in higher education associated with the coalition government's privatisation agenda (a policy that nobody voted for) that does not in any way benefit the members.
The existing policy of the USS is to invest in assets that will produce an income in the long termto match the long-term liabilities of pensions. This is a good principle if the university sector has an indefinite time horizon as a public service.
But that has been changed and now universities are seen as just companies in the market. The regulation of their pensions comes under the same umbrella as for a private company that could go bust or be taken over. Therefore the pension scheme must be accounted for on the balance sheet like any other assets and liabillities. Logically it would then make sense to split up the USS among its member institutions, which is on the cards.
Under this approach the pension scheme must be fully funded at all times to ensure that it will be possible to pay the pensions even when a university goes bust. At present that is not the case so the trustees plan to move to this situation gradually over 20 years by selling assets that bring a high return - mainly equities - but whose market prices are volatile due to the irrational stock market and buying government bonds - gilts. That is a strategy of playing it safe.
Somebody has to pay for de-risking. The trustees want it be members. Arguably since the whole need for de-risking stems from the privatisation and marketisation agenda of David Willetts the government should pay to ensure the pensions guarantee. In other privatisations such as the post office the government have taken on the pension liabilities.
The proposals are grossly unfair and it is hoped that the employers and our negotiators will be able to agree to reject that part of the document.
November 18, 2014
The methodology that is used for the valuation of pension schemes in the UK is based on theoretical financial economics. The paper that argued for this approach to be applied to pensions is by Exley, Mehta and Smith: The financial theory of defined benefit pension schemes, published in 1997. It is a very long paper and has been hugely influential.
A critique of it (together with a very readable account of actuarial principles) can be found in the attached paper by Simon Carne simoncarne_truth.pdf.
It argues essentially that the approach to pension scheme valuation traditionally used by actuaries leads to inconsistencies relative to a strict use of market prices. The theory is that no one individual actuary can know the prices of assets better than the market.
This is logically flawed because it is a circular argument. The market consists of many human beings all of whom must behave in the way that is being criticised: that is, they must strive to do better than the market in order for the market to work. If all market participants all simply acknowledged that they could never beat the market, and decided to follow it, as this paper recommends, then market prices would become arbitrary and the theory would collapse.
A second criticism is that the argument is entirely in terms of a priori deductive theory and there is no consideration given to the empirical evidence to support it - that is, whether it actually seems to work in practice. Faced with the commonplace evidence that asset prices are very volatile - because their supply and demand depend on many other factors besides the theoretical model of the expected present value of future earnings - one cannot avoid being highly sceptical. The theory is offered as being based on fundamental economic principles which one would expect to lead to robust values that would vary only when parameters of the model change, rather than varying when those parameters do not change.
The effects of economic and political shocks that are essentially due to other factors can be much more important in explaining the volatility - thereby undermining the theory. Irrational factors that reflect herd instinct by investors can cause large swings in asset values that are nothing to do with a rational judgement about the expected future return on those assets.
November 05, 2014
Frequently Asked Questions about the USS
What is the deficit?
The word ‘deficit’ normally means the amount by which income falls short of spending.
That is not what is meant here. The USS is actually in surplus in the normal sense. But the term ‘deficit’ is being used as a technical term to mean a balance-sheet shortfall between the liabilities and the assets. This is a theoretical stock of capital rather than money that necessarily has to be found in the ordinary day-to-day business of things.
It is a bit like negative equity on a house. If house prices fall many people will find their mortgage debt greater than the value of their house: a situation known as negative equity. That happens fairly often and is not usually regarded as a problem that has to be dealt with. We see it as merely a temporary situation until house prices recover in the normal course of the economic cycle. It does not mean that the householder has to suddenly find the money to pay off the difference.
Another analogy might be the national debt. It never has to be paid off and causes no problems as long as the government can pay the interest, something it has never been unable to do.
But we are being told the USS pension deficit must be paid off as soon as possible regardless of the state of the economy. It is rather as if your mortgage lender was telling you to find the cash now to pay off your negative equity in an emergency recovery plan.
The UCU is contesting the valuation methodology. How is it possible to do that if the law is clear that pension schemes must be valued every three years?
Things are not black and white. There is not a single natural way of valuing a pension scheme. Any valuation depends very heavily on economic theory, and there are different theories about what a pension scheme is. The law allows for different approaches to be used. However the regulator, many actuaries, trustees and accountants tend currently to be taking an approach that would at one time have been regarded as overly prudent. Prudence can be taken to extremes such that instead of leading to a cautious appraisal, the survival of the pension scheme itself is threatened. This has been dubbed ‘reckless prudence’.
Traditionally the actuaries used to take a long term view taking account of the likely income earned by the investments in the future in relation to the pension promises. This would allow for temporary effects due to the inevitable economic cycles. This approach (known as smoothing) is not allowed to be used under the rules that are being applied now. Valuations must be based on an ideal theory that markets are efficient and no judgement or forecast can be any better than that of the market. So actuaries cannot take a view in the way they used to do. Essentially there is no room for macro-economics any more. There is only the micro-economics of the efficient markets hypothesis. But the efficient markets hypothesis is contested by economists, actuaries and accountants. The fact that this approach is being effectively imposed is market fundamentalism, based on a neoliberal world view.
How are the assets valued?
The law states that the assets of a pension scheme must be valued at market prices. There has to be a valuation every three years on March 31. The theory behind this is that the assets are the fund out of which the pension promises are paid. But for a very large scheme like USS that is not a very practical concept because it is not possible to sell large quantities of assets (currently about £40 billion) without causing a crash.
But it is not really market prices that matter so much as the income that the investments will bring. Earnings from dividends, interest, rent and so on are what are important. Yet these are ignored.
The idea of using the market prices of the assets to assess the health of the scheme comes from a particular economic theory known as the efficient markets hypothesis that holds that the market price of an asset reflects all future information about the earnings the asset can yield. So it is not necessary for the actuaries to forecast the future income because the market – as if by magic - has already done the work for them. This is an elegant theory with very little if any empirical support. In fact all the empirical evidence shows that asset prices are very much more volatile than earnings from dividends etc. These fluctuations in asset prices reflect short-term macro-economic and political conditions external to the scheme and are not directly relevant to the solvency of the pension scheme in the real world.
How are pension liabilities calculated?
The liabilities are the most problematic part of working out the funding position, because the liabilities are long term promises of pension benefits into the distant future. The methodology relies very much on economic theory and produces a figure that is not only highly volatile like the assets but also the methodology behind it is highly questionable anyway. The figure derived for the liabilities only makes sense under very strong and unlikely assumptions.
The idea is to calculate what would be a suitable sum of money that would enable all the pensions promises to be paid on the assumption the scheme were wound up. That is the theoretical basis.
This requires an assumed notional rate of interest known as the discount rate. We are told that prudence dictates that we cannot assume interest rates will every again increase above their current very low level. The economy will never recover. Also prudence dictates that we assume the worst about life expectancy, future inflation, future pay rises, and so on. Thus we must assume that pay continues to rise faster than inflation (despite recent experience to the contrary) yet the economy does not grow at anything like that rate. Also we are told by the EPF that life expectancy is growing at something like almost six years every decade despite evidence from the Office of National Statistics that it is more like less than two years.
The economic model that drives thinking on this is where the pension scheme belongs to a company that might go bust (or maybe the chief executive might steal all the pensioners’ fund then commit suicide as happened with Robert Maxwell at Mirror Group). In the case of the USS it is a group of universities.
But the USS is a huge scheme covering an industry rather than a firm. This model does not fit the reality.
It is said by many critics that the USS is very poorly managed. Isn’t the problem that the scheme does not invest its fund well?
No. This is often said but the criticism is unfair. In fact USS investments have been performing relatively well. Not perhaps the best in the industry but certainly well above average. Last year the USS made a rate of return of 7.6%, 1.4% above its benchmark:
The USS is often criticised for having invested in the wrong sort of assets. It is heavily overweight in equities which are risky and it needs to rebalance.
This argument has been around for a long time and has never been rebutted. It is fallacious and allowing it to go unchallenged has done a lot of damage to the reputation of the USS.
The argument is that equities – that is stocks and shares of companies – are inherently volatile in that their prices vary a lot over time. So a prudent pension scheme should not rely on this type of unreliable asset class too much. USS has traditionally invested in equities and has too many in its portfolio.
This argument is wrong. A pension scheme like the USS covers a whole industry – a public service actually, higher education – so it has a long time horizon. It is not like a pension scheme for a company that might have a finite life cycle and then go out of business. In that case it makes some sense to get out of risky equities as the members approach retirement because there needs to be a secure income to pay the pensions.
But actually for an infinitely lived scheme the risk in equities can be removed by holding a diversified portfolio. Investing in a wide range of company shares across the whole economy enables the scheme to get a good return on investment long term while avoiding risk through both diversification and intertemporal smoothing. That is what is described in the USS “Statement of Investment Principles”. (It is known as the equity premium.)
The USS has to invest its surplus of over £1 billion per year. Where should it invest if it is to get the highest return? Increasingly it is investing in alternatives which includes infrastructure. It recently bought a large chunk of Heathrow, NATS, Sydney airport, etc. These investments share many of the characteristics of equities – they give a good long-term return that matches the long-term nature of the liabilities.
What is de-risking?
It sounds like something we should all want – getting rid of risk is like being against sin – but it is actually a technical term used in the pensions industry. Many DB pension schemes are closed to new members or future accrual. Most of their income comes from investments. As the members approach retirement and retire the need is for the income to become more secure. The investments are moved from risky but rewarding assets like equities to safe assets like government bonds (gilts).
The trouble is that the same logic is being applied to the USS – it is being treated as if it is to close. So holding a diversified portfolio will cease to make sense. If assets are moved to the lower earning gilts then the income lost has to be found. Hence the cost of doing that is being added to the deficit. That has to be paid in increased contributions or reduced benefits.
Why is this logic being applied? It is not necessary that the USS be regarded in this way. It is an infinitely long-lived scheme. The only thing that will lead it to fail is if members do not join it – and making them pay for de-risking is one way of ensuring that happens.
A policy of de-risking is not reducing risk at all. In fact it is increasing the risk. The employers are not saying that they want to address a deficit of 'only' £8billion. They are saying that the deficit is unsustainable because it is going up to £13billion as a result of derisking!
According to their latest briefing the UCU negotiators seem to be ambivalent about de-risking. They should reject it entirely on principle. We should defend the USS as a sector-wide pension scheme with an infinite lifetime continuing into the indefinite future.
What does the law require?
The regulations are laid down in general terms in the Pensions Act 2004. Pension schemes must be valued every three years. How this is done and the procedure when there is a deficit are described in the code of practice in the associated order in council, here.
But the most problematic clause is 128 which rules out smoothing on the grounds it is inconsistent with the strict market prices. This means that a very strict theory of market prices is taking precedence – market fundamentalism. It is based on the belief that markets are perfect and effiicient.
So what is the nature of the crisis?
The legislation gives wide discretion to the trustees and the regulator. The regulator is concerned primarily with protecting the pension protection fund from any claims on it. The regulator does not have to give priority to providing a good pension scheme for members.
The trustees ought to be taking a view. In the case of USS it is usually thought of as long lived (an immature scheme). So the deficit does not matter - it is cyclical and will disappear as soon as interest rates on gilts increase.
But they are not thinking in these terms any more. They are in Willetts' world of competition between universities that are treated not as public bodies but private companies operating in the market place and competing with new entrants. There is no difference essentially between, say, Oxford and BPP university. If a university fails to attract enough students it will be allowed to go broke. So from this point of view prudence requires a need to have its pension promises funded at all times. That is its share of the USS. Hence the deficit begins to matter enormously. So although the sector as a whole is presumably not going to go bust each individual institution can do so. This new thinking - privatisation - is what lies behind the employers thinking.
That is why they want to introduce de-risking. Nothing to do with equities not being a good investment. Equities are the best investment for a long-term pension scheme like USS if it is seen as covering the whole sector. They have a higher return and the risk can be borne because it does not matter in the short term - the pension scheme does not need to draw on its assets in the short term.