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August 17, 2018
Evidence to the Joint Expert Panel
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.
- 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.
- 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.
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. 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.
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.
 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)
 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.
May 02, 2018
(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.)
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 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.
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.
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.
April 07, 2018
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.
March 21, 2018
The following response from a member was passed on to the UCU Pensions Officers discussion list by Sunil Banga
Thank you for your “Urgent update from the USS trustees”, which I received on 17 March 2018, and which helped to dispel some of the rumour and disinformation that has circulated around the pensions issue. It is a great relief to learn that I am not expected to live to 147 years of age.
A number of other even more scurrilous and damaging pieces of misinformation have come to my attention, and I hope you can clear up these pieces of mischief before they inflict further damage on the reputation of USS and the higher education sector.
I have heard a vicious rumour circulated by the BBC’s education and family correspondent that the chief executive of USS, Bill Galvin, received an £82,000 pay rise this year, bringing his pay package up to £566,000 per year. Only the most hardened cynic could believe this. It would, after all, mean that his pay rise alone is greater than the annual salary of many of those whose pensions the USS has proposed drastically to reduce.
What gives this rumour a particularly nasty edge is that after claiming that the running costs for the pension scheme are £125 million per year, including two staff members earning more than £1 million, the BBC correspondent quotes Mr Galvin as saying that the pension scheme is “excellent value”.
I think it would be a good idea to ask the BBC to publish a retraction, because this sort of rumour is likely to undermine the reputation not only of USS but of the higher education sector as a whole. I hope I will receive another urgent update on this matter as soon as possible.
An even more damaging piece of misinformation surrounds the results of the September 2017 survey of member institutions of USS. USS reported the survey found that 42% of employers wanted a lower level of risk. This finding justified the “de-risking” exercise that increased the projected deficit in the pension fund and which ultimately gave rise to this unfortunate dispute. Could there be any greater mischief than the ugly rumour, originating with the Financial Times’s pension correspondent, that UUK “told the FT that Oxbridge colleges accounted for one third of the total wanting less risk” because Oxbridge colleges “are employers in their own right” and hence each college was counted as having an independent vote? If a third of those wanting lower risk were Oxbridge colleges, this would mean that, beyond Oxford and Cambridge, the opinions of barely a quarter of the respondents to the survey justified the reduction in benefits that led to the strike.
Anyone gullible enough to believe that USS would accept this sort of gerrymandering must think that we still live in feudal times! I think it is important that USS nip this story in the bud. It is the sort of thing that might otherwise lead to the complete collapse of trust in both USS and UUK.
The thing that worries me, though: how did hackers manage to plant these stories with the BBC and the Financial Times correspondents? Could this be part of a concerted digital attack by a hostile foreign power?
As if that weren’t enough, the rumour-mongers must have hacked into Cambridge University’s response to the September 2017 survey, in which one finds the following justification for lowering the level of risk: “The University (and the other financially stronger institutions) continues to lend its balance sheet to the sector, which contains the cost of pension provision for all employers. In a competitive market for research and student places the University would be concerned if this appeared to be having an adverse effect on the University’s competitiveness (by allowing competitor universities access to investment financing or reducing their PPF costs in a way that would not be possible on a stand-alone basis).”
No one could possibly believe that Cambridge University would be so selfish as to drive the whole education sector into turmoil in order to improve its relative position on the capital markets vis-à-vis other universities—or that the USS posture would collude with this sort of behaviour.
I hope you can see the urgency of correcting this bit of misinformation. The mystifying thing, though, is how someone has managed to plant the quoted statement in Cambridge’s response to the September 2017 survey, found on Cambridge’s own website. What evil force is trying to tarnish higher education in this way?
What USS must correct most urgently of all, though, is the following narrative: that in 1996, rather than build up a healthy surplus, USS permitted the employers to reduce their pension contributions from 18.55% to 14%, on the understanding that there would be no reduction in benefits; that the employers reduced their funding between 1997 and 2009, when hard times hit us all; and that when the fund was found to be in deficit, rather than ask the employers to pay a surcharge to compensate for their earlier reduction, USS instead instituted a series of reductions of benefits to the pension beneficiaries.
This story is the most damaging of all. Any child who has been immunised against profligacy by the fable of the grasshopper and the ant would recognise the impropriety in allowing the grasshopper employers to reduce their contributions in the apparently endless summer of 1997 to 2009, then requiring the employees (who, conscientious as we are, never reduced our contributions) to accept lower benefits in response to bad times. No responsible adult would let the employers get away with this, let alone an organisation like USS with fiduciary responsibilities. If we were to believe this story, we would have to believe that every time push came to shove, the independent chair of the Joint Negotiating Committee sided with the employers. That is not possible, because the very first words of the “urgent update” you just sent say that USS “has the primary duty to act in the best interests of the scheme’s beneficiaries”. No organisation would be so shameless as to allow itself to quote those words having permitted the employer to treat the beneficiaries in the way this mean-spirited story recounts.
I do hope that USS sees the urgency of dispelling the rumours that I have reported. If they continue to circulate, they will reinforce the belief that USS has acted as the servant of the most aggressive employers in the sector, who want to improve their balance sheet position even if that poisons relations between universities and their staff for a generation, destroys trust in USS and UUK, drives university employees into penury in their old age, tarnishes the reputation of the higher education sector, and thus does irremediable harm to the nation.
I look forward to your next urgent update containing apologies from all of those whose words and actions have brought USS and higher education into disgrace.
With my best wishes,
a USS beneficiary
 Sean Coughlan, BBC News education and family correspondent, “University Pension Boss’s £82,000 Pay Rise,” http://www.bbc.co.uk/news/education-43157711.
 “UUK Responds to USS’s Consultation on Funding Proposals”, https://www.uss.co.uk/how-uss-is-run/valuation/2017-valuation-updates/uuk-responds-to-usss-consultation-on-funding-proposals.
 Response to Question 3B, “University of Cambridge
Responses to Questions from the UUK Survey on the 2017 USS Valuation,” https://www.staff.admin.cam.ac.uk/general-news/uss-pension-valuation.
March 16, 2018
Writing about web page https://www.ftadviser.com/pensions/2018/03/15/why-pensions-are-worth-striking-over/?page=1
This is my response to what Sally Hunt, the General Secretary of the University and College Union, has written about the latest develpments in the USS dispute on the FTAdviser website.
What is puzzling is why the union has asked for the employers to increase their contributions, and agreed that members should pay more, when the key issue is the valuation methodology which points in the opposite direction. The union committed a strategic error when it did this. It is to be hoped that it can retrieve itself from it.
Fundamentally the dispute centres on the strength of the employer covenant: that is, the member institutions’ ability and willingness to support the scheme. Because the employers can collectively stand behind the scheme indefinitely, due to its “last-man-standing” structure, the covenant is patently strong. The UCU should not compromise on this point in any way.
This means that the USS can remain open to new members and accrual indefinitely and put its spare funds into investments that will make a high return over the long term. Remember that the scheme makes a large surplus every year - almost £1 billion - and this is what it has been doing very successfully for many years. Forecasts of income and outgo, going well into the distant future, that have been made by the UCU actuary, have shown that continuing with this strategy can provide the pension benefits promised to members. On this basis, there is not a large so-called deficit. There is probably a surplus – for example as is indicated by the Best Estimate valuation in the September USS consultation document.
The problem is that the different valuation methodology being insisted on by the employers (and the USS executive) contains a sleight of hand that makes it seem like there is a large deficit. They use circular reasoning that contains a serious inconsistency. The negotiations and industrial action should have been - and should still be - directed at this, in effect, big lie.
We know that the design of the scheme is 'last-man-standing' where all the institutional members support one another against the prospect of individual institutions being unable to support the scheme. The bankruptcy of one university, for example, leaves all its member staff’s pensions entitlements unaffected. This is obviously a very strong covenant because simultaneous bankruptcy is not a plausible eventuality given that all the pre-92 universities are well established institutions of great public benefit and always will continue to be so collectively, even allowing for some reorganization, such as mergers and closures of some institutions.
But if, on the other hand, we consider a scheme for employees of – let us say – a private company that operates in a risky market place, there could only be a very weak covenant. There would be a lot of risk. The scheme’s portfolio investments would need to be in low risk assets such as bonds in order for the scheme to be able to pay the pensions in the not unlikely event that the business eventually closes. This means more cash must be provided to pay the benefits, and the liabilities, must be very much higher than if the covenant is strong.
Therefore it is clear that an assessment of the covenant should be based on an objective appraisal of the likelihood of the scheme closing, independently of the pensions liabilities. Having a high pension liability is not in itself an argument for saying the covenant is weak. That would be circular reasoning because the estimate of the liabilities depends on the strength of the covenant.
Yet that is precisely what the UUK employers and the USS executive (and even the pensions regulator) are doing. They all base their covenant assessment on a hypothetical view of the ability of the sector to support the scheme in financial terms. This puts the cart before the horse because their liabilities estimate assumes there to be a high risk of failure – a weak covenant in the first place. They are using circular reasoning and have slipped in the conclusion they appear to wish to arrive at: that the scheme is too risky to be sustainable.
The UCU negotiators should point this out. And they should not accept these arguments that show the covenant to be weak based on an implicit assumption that it is weak in the first place.
Best Estimate valuation
As an aside, we are told that the Best Estimate valuation can’t be used because it will be correct only 50 percent of the time, therefore as likely to be wrong as right. This is both wrong and irrelevant. Where the employer covenant is strong, the scheme trustees need not worry about short-term volatility of its investment portfolio, and can invest in high-return assets for long term income. The liabilities should be estimated using the Best Estimate of the portfolio return, with a suitable margin for proper prudence, of course.
What is an Independent Review?
Finally, there is the question of the proposed panel of independent experts. It is a very unwise move for the union to agree to this. Not only does it beg a number of questions about the composition of, and procedures to be followed by, this group, it also says that the union has little confidence in the case it is putting forward.
How will the members of this group of experts from academia and the pensions industry be selected? There are very many senior academics who are expert in accounting and finance who do not question the received industry norms of what are often called generally accepted principles. There are even Nobel prizewinning economists among them. Yet it is precisely such principles that we must challenge. The UCU policy is in fact to argue against the application of the conventional valuation of pension schemes used by company accountants.
Many if not most actuaries have been persuaded that they should employ the tools of modern finance theory such as the efficient markets hypothesis. Such is evident from some of the statements by the pension regulator and the USS Executive, also many actuaries. Would we expect an independent expert to agree with or criticize this kind of analysis? The actuarial profession was told a few years ago, in several reports, that they ought to use ‘modern finance theory’. They have taken this advice to heart. Yet this is precisely where the problem lies, and to call for the whole matter to be delegated to an independent panel of experts is to back away from dealing with the issue.
Then there is the question of how the expert body will be constituted. Will it include members who have expressed views in the debate already, or does the word independent preclude them? Will it meet in public? Will its deliberations be open to scrutiny? Will its membership be limited in number? In other words, will this independent group be subject to the normal modalities of academic enquiry and discourse? It is after all the function of academia to find out the truth by open, free debate. That is what universities are for.
September 15, 2017
The reports that have appeared in the press that the USS is in deficit of so many billions of pounds (Times Higher, Financial Times) are very one-sded and misleading - not least because the precise figure seems to change massively each time it is quoted. The latest valuation - actually dated 31 March 2017 - is in progress. The scheme's trustees are currently consulting the university employers about the approach they are following.
The document laying out the assumptions and the questions the universities are being asked has been made available to members if they request it. Members should ask their employer. It has also been published on its website by Sheffield University, and can be downloaded from here.
The calculations that have led to the conclusions reported in the press are based on a very particular view and approach the USS executive want to follow. This is the belief - handed down by generations of actuaries - that pension schemes should invest their funds primarily in government bonds (aka gilts), on the principle that such investments are totally safe, whereas equities are somewhat risky.
The problem with following this maxim in today's economic conditions is that - as a result of our government's policy of very low interest rates - is that it gives a very poor return, one that is currently below inflation.
In other words following their own orthodoxy is irrational: the principle of investing in low risk gilts is a guarantee of losing money in real terms!!! Yet despite their best efforts the UCU has been unable to get them to question their professional norms, and to consider other assumptions, even if it means the pension scheme having to close to defined benefits as a result.
The document's reference to poor investment returns largely reflects this assumption. Yet returns to investing in growth assets are not too low. For example equities continue to give a dividend yield sufficient to meet the anticipated pension obligations.
At the core of the valuation problem is the so called Test 1 which is somewhat technical but requires university employers to make up for the loss by extra payments. But their capacity to make such additional payments is limited. Hence the threat to the affordability of the scheme. But Test 1 is a very specific methodology whose evidential base is open to question. It assumes the only investments are loss making gilts. It would be good to know how the test would work on the assumption the scheme is invested in the actual assets it has. It is puzzling why this is not done.
The draft valuation assumes implicitly that the scheme must be seen as about to close to new members and always remain invested in low-yielding but secure gilts. But the scheme is open to new members, and serves a sector with strong employers - the pre-92 universities (in other words not the former polytechnics but the older, more famous and well established institutons from Oxbridge via the Red Brick Civics to the New Universities founded in the Sixties) - and therefore can invest for the long term. Because it has done this over many years, the USS has an investment portfolio that is mainly concentrated in growth assets such as equities and few gilts - so the assumptions of the executive are not relevant anyway. These investments do well and make a return sufficient to pay the pensions - as long as the scheme remains open.
The UCU's actuary First Actuarial has just published their response to the USS valuation. This assumes the scheme remains open, continuing indefinitely with the profitable investment portfolio it actually has (rather than loss making gilts). The bottom line is that there is no need to cut pensions benefits or raise contributions:
"We conclude from the cash flow analysis later in this report, that the current contribution rate from the 2014 valuation remains a prudent contribution rate, given the current benefit design of the USS. In a scenario of “best estimate” pay rises, the benefits of the USS can very nearly be paid from contributions, without reliance on the assets. There is no need to change either the contribution rate or the benefits to have a prudent funding plan. The strong likelihood is that the USS can be invested to outperform the return required to safely deliver the benefits. Given time, the outperformance will increase the funding level to any desired target. Any formulation of the sign off of the valuation which maintains the current contribution rate and the current benefits is acceptable."
All USS members interested in what is happening - or likely to happen - to their pension rights ought to read this document.
August 11, 2017
Everybody should keep calm about the universities superannuation scheme. Contrary to sensational press reports last week in the THE, Financial Times and BBC, the USS is not actually in deficit - not in the usual meaning of the word ‘deficit’ anyway.
If it were truly in deficit it would not have enough money coming in to pay its outgoings. It would be forced to sell some of its investment portfolio to keep going. But in reality it has investment income each year in excess of £1 billion which is not needed to pay for pensions today and that is available for new investments. It has just bought a large stake in Thames Water, for example. The scheme is cash rich and can remain so for many years. Membership is increasing with over 29,000 new members joining last year.
What, then is the problem? The headline figures quoted are theoretical numbers based on particular hypothetical assumptions about the future, whose realism is in doubt. Many members, the UCU, some universities and some actuaries are questioning whether they really give a true picture of the health of the scheme.
The ‘deficit’ emerges as the difference between the scheme’s assets (its investment portfolio) and liabilities (the value of future pensions benefits). The press reports are sensational because they quote raw figures baldly without any context. The liabilities are estimated to be £72.6 billion, which, with assets of £60 billion, means a shortfall – the ‘deficit’ – of £12.6 billion.
Reporting figures like that as raw numbers, expressed as billions of pounds, without putting them in context is misleading. (It is reminiscent of the way that government debt and deficit are reported in absolute numbers in order to frighten us into accepting cuts in public spending.) Given the size of the USS, with almost 400,000 members, it is actually not surprising that the figures are so large. They need to be put in proper context before any conclusions can be drawn. They represent a funding ratio of 83 percent: the assets are currently worth 83 percent of the liabilities. So is that high or low?
Compared with the funding levels of the almost 6,000 private UK schemes, of which the USS is the largest, it is not out of line. Its funding ratio is fairly typical. The average for schemes in deficit is 83 percent, according to the Pensions Regulator Scheme Funding Statistics 2007. The BT pension scheme funding ratio is 64 percent.
So it is not fair to say, as the FT article claimed, that the USS has the largest gap between assets and liabilities of any scheme in the UK. It is only large because the scheme is very large.
While the USS ‘deficit’ is not out of line with other privately funded schemes, we still need to ask where it comes from in the first place and what it means. The main reason for pension scheme deficits – not just USS – is that the accountants tend to insist on an assumption that schemes be invested only in bonds (even though that may not be true). In this they seem to be following a herd mentality and advocating something which is irrational. Why anyone would believe that investing in gilts at the present record low real interest rates, which entails expecting to make a loss, reduces risk is hard to understand.
But gilt interest rates have really very little to do with the USS pension scheme. After all, the pensions that members will receive are not paid out of the meagre returns from gilts but the much better returns from the long-term investments the scheme actually has, that it has built up over the years, mostly equities and other high-return assets. Such assets – if held for the long term - yield a high return with minimal risk.
[The USS uses this best estimate rate of return to value liabilities but with a substantial – some say excessive – margin of prudence to allow for market volatility of equities and other assets (the technical provisions). However they update this figure regularly using gilt rates, and it is this that appears in the accounts.]
The report also gives an alternative figure for the deficit if liabilities are valued using the actual rate of return from its assets but without the large dollop of prudence. This ‘best estimate‘ for the liabilities figure (as at 31 March 2014) was £38.1 billion, which means the scheme would have been in SURPLUS by £3.5 billion! Of course the necessary degree of prudence needs to be applied here, but it does show that this is not a scheme that is in trouble. We are due another triennial valuation in the next months (with a reference date of 31 March 2017) and it seems likely that the best estimate valuation could well have improved.
Members should stay calm and insist that the scheme remain open to new members and accrual. The biggest threat to the scheme is closing it.
May 08, 2016
An article in last Saturday's Times, 'Universities' pension scheme could face their most rigorous examination' is an object lesson in the poor standard of reporting on pensions. Its author, Philip Aldrick, is the paper's Economics Editor, yet he displays a poor understanding of the underlying issues he is reporting which leads him to mislead the reader.
He is telling us about the large deficit that is being forecast to emerge from the next valuation of the USS, the private pension scheme that covers staff of the older universities, what are known as the pre-92 universities. The newer institutions, mainly the former polytechnics, are covered by the teachers' pension scheme, guaranteed by the taxpayer. But the USS is private so it comes under the same regulations as company pension schemes, such as the BHS.
But there the comparison ends. Questions are being asked in parliament about where the BHS pensioners' money has gone: there are some fairly simple and obvious question marks surrounding the role of the former owner of BHS, Sir Philip Green.
The USS deficit is not like that in that it is not clear where the deficiency is or how it has arisen. We cannot blame anyone for taking too much money out. We are told that at the last valuation in 2014 there was a deficit of £5.3 billion and that a recovery plan was agreed involving cuts to benefits and increases in contributions which were designed to fill the gap. Yet only a year later the deficit had become £8.2 billion. And it is estimated that by the next valuation in 2017 it will have ballooned to £11 billion.
These changes have taken place with nothing substantial changing in the actual scheme itself: there has been no Robert Maxwell raiding the pensions pots of his employees, no university finance officers indulging in creative accounting, no sudden mass retirement of thousands of senior professors on high final-salary-linked pensions, no sharp drop in recruitment. On the contrary changes in pension scheme deficits on the scale reported would only normally be expected to occur over perhaps a decade or longer, not a period of months. And they would be explained in terms of tangible factors such as increased longevity. But forecast longevity does not increase in big sudden jumps on the scale needed to explain these deficits.
No. These big swings in the deficit are almost entirely artificial. They are due to the regulation rules which have an inbuilt bias towards finding a deficit. This is is a problem that affects all defined benefit schemes: USS is merely the largest and therefore the effects are greater.
Many of the pension deficits stem from a major mistake by the government in basing regulation on what is called ‘modern finance theory’ or ‘financial economics’. Pension schemes have to be valued in terms of assets and liabilities, which are categories of capital, when what actually matters is whether the flow of income is enough to pay the benefits into the future. Capital values and income flows are two completely different things. It does not matter what the prices of the scheme’s investments in shares are on a particular valuation date; what we want to know is how much income those shares are likely to bring while they are held in the portfolio.
Theory teaches us that the capital value of an asset is the discounted present value of the expected net income received by its owner. That theory is the basis of valuation required by the pensions regulator. But we should not listen to that theory because it does not hold in practice. In reality share prices are highly volatile, far more so than the economics supposed to underly them. The asset valuations are far more volatile than the dividend and other income as a result of natural speculation in the stock market and other reasons like sentiment, 'irrational exuberance', and so on. There is massive evidence on this. There is a wealth of literature showing that excess volatility exists and that it is large; some studies have found it to be an order of magnitude greater than the volatility attributable to underlying economic events.
Yet the legislation on valuation of pension scheme assets requires it to be done in line with finance theory: by pricing to market and taking the ensuing volatility as risk and therefore something important to be managed. If anyone points out that there is excess volatility in the real world, it is dismissed as a merely a 'puzzle'.
The liabilities, too, have to be estimated in a way that makes it possible to compare a figure for them with the assets. (This is where the 'complicated mathematics' of the article comes in: Mr Aldrick reveals he is not well-up on pensions economics when he sneers at this.) The liabilities figure is an even stranger concept than the assets. And this is where most misunderstanding comes from. Most journalists do not understand how artificial and divorced from reality the liabilities figure is.
Under the rules the trustees of a scheme have to work out a hypothetical capital sum that - if it were invested in a certain way - would produce the assumed future benefits. The regulations actually allow for quite a lot of discretion in how this is done but most actuaries have got the idea from finance theory that investing in gilts is risk free. The problem with this is that gilt rates are very low at present so this means liabilities are very high. And as gilt rates change by a small amount the liabilities change massively by billions. (It is not a risk-free rate if it is constantly changing.) Yet the real liabilities are the benefits that have to be paid in the future and have not changed, they are just the same. Once again it is theory in the face of evidence: real pension schemes do not invest in gilts but in assets that will give a high return, in a prudently diversified portfolio.
The third major factor is the employer covenant. When USS was set up it was backed by the government. Any deficits could be made up by changes to the grant. The UGC (later HEFC) had a seat on the Board. So institutions did not have to worry about risk of the scheme failing. But the government (Willetts I assume) withdrew in 2011 and the scheme, as the article says, is a last-man-standing scheme. This seems to be exercising the minds of some of the employers worried about taking on the liabilities for institutions that fail in the new competitive environment where we are being under-cut by cheap new entrants. So the valuation - I believe - currently assumes only a twenty year covenant: to be on the safe side universities are assumed not to contribute beyond that. How likely is it that institutional members of the USS - the pre-92 universities mainly - will go bust.
Members are having to contribute more and more to the scheme, and benefits are being cut, in order to manage a lot of synthetic risk in the form of market volatility which is not the same as actual risk. On top of that they are having to pay to manage the risk of institutional bankruptcy.
Mr Aldrick finishes with an extraordinary comment: "The big hope is that interest rates rise which, through complicated mathematics, will reduce the liabilities. If that is the plan, however, it would make Sir Philip look as clean as a whistle. Universities, we'd like to think, measure themselves by a higher standard."
This statement suggests he does not appear to get it. He does not seem to understand that the reason that the liabilities figure is so large is mainly due to low interest rates but instead seems to believe the deficit is real and that the effect of a rise in interest rates 'through complicated mathematics' is somehow an extraneous technicality that might be as morally dubious as the shenanigans at BHS. The fact that interest rates are low is the reason the deficit appears so large.