April 07, 2018

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.

April 05, 2018

Call for rethink on regulations based on the USS dispute

This letter by two senior pensions professionals, Frank Curtiss and Tim Wilkinson, published recently in the Financial Time sets out with absolute clarity how it is badly thought out regulation that is harming pensions.

They say, “actuarial and accounting standards, bolstered by several pensions acts, have become alarmingly divorced from the economic reality of running a defined benefit scheme.”

They suggest that the employers’ body, the UUK, and the members’ union, the UCU, combine forces and effect “a shift in the regulatory balance back towards a sensible view of real-world pension costs” and call for “A sustained large-scale academic assault on decades of regulators’ mistaken focus on point-in-time market values and inappropriate discount rates”

curtiss and wilkinson

March 24, 2018

Why the UCU should not leave the USS valuation to the proposed panel of selected experts

I have serious concerns about the latest proposal agreed between the UCU and UUK to set up an expert panel and agree to whatever they come up with. The panel is to be made up of both actuaries and academics with an ‘independent’ chair.

The UCU general secretary Sally Hunt has written to members recommending it but I find her approach worrying. She is approaching the issue of the pension scheme valuation as if it is a wage negotiation where two sides present their positions and there is a compromise; it is simply a matter of more or less money. This way of looking at the issue is worrying since it concedes too much and ignores the main point.

The issue is about the methodology that is being applied. It is also about language. It is hard to see how there can be much compromise when two sides use the same words to mean different things.

The fact is that the scheme is – literally – not in deficit. It is in large cash surplus year after year. That is a matter of plain fact. There can be no argument about it. It is not putting an optimistic gloss on assumptions or theories about the future. It is to merely to use the words to describe the state of the scheme in their ordinary meaning. Deficit: “The total amount by which money spent is more than money received”.

By contrast the employers use the word ‘deficit’ as a technical term which belongs to a particular theoretical approach. It measures the difference between capitalised values of assets and projected benefits calculated on very strong assumptions.

We should insist that the starting point of the discussions is that the scheme is in surplus and we should not appoint any experts who do not also start from that position.

The difference between the two sides is one that is familiar in Keynesian economics, between uncertainty and risk, a distinction due originally to Frank Knight. In any decision situation the future is, naturally, unkown. If that lack of knowledge is fundamental to the socio-economic conditions that will prevail and events that will happen that cannot be forecast, then it is a case of radical or Knightian uncertainty. Examples would be the possibility of a war, a recession or market crash.

The other situation, referred to as risk, is where the future can be defined in terms of a phenomenon that is subject to the laws of chance. That would be where probabilities can be defined and calculated on the basis of regular patterns of behaviour that can be observed. Examples might be natural phenomena such as weather events, or the tides. An important application in pensions and insurance is to mortality rates, the unique domain of actuaries. Risk requires well defined probabilities to define the relevant laws of chance. While the future outcome is unkown, it is possible to make precise probability statements about the likelihood of it being in certain ranges.

The difference between the two sides in the debate about the future valuation of the USS is between those who believe it is a matter of uncertainty and those who think it is all a matter of risk and that the probabilities can be found from market data. My view is that the stochastic behaviour of market assets like equities, bonds and real estate cannot be characterised by stable probability distributions. The belief of the risk analysts is that the return on every asset has given expected value and risk. Moreover, the return on every pair of assets has a well defined covariance that can be relied upon to remain constant throughout every eventuality. These extremely strong assumptions are at the heart of the methodology that we are challenging. Yet many highly respected financial experts and actuaries accept and use them with insufficient scepticism. They have often proved wanting because human affairs drive markets not natural phenomena. They should be regarded as situations of uncertainty not risk.

Coming back to the main issue, of how the panel of experts is to conduct itself, the question that has to be determined is what happens in the future. Will that surplus continue indefinitely or will it eventually turn into a deficit. When will that happen? If it goes into deficit, how large will that be and can it be covered by the sale of the investments or not?

To answer these questions will require the help and cooperation of the USS staff who have the necessary data. The UCU’s actuary, First Actuarial, tried to do this analysis for us some months ago, but they were unable to do more than provide indicative figures due to the lack of help from them. They were nevertheless encouraging and suggested the scheme would not run into a funding crisis. The union should insist on this approach rather than leaving it a panel of experts with ill-defined terms of reference.

Whoever the union appoints as expert members of this panel must understand this and not simply go along with the conventional industry approach based on the use of pretty feable probability measures. It will be difficult for the panel to operate because it will be confrontational: ‘our’ experts will have to win over ‘their’ experts. It is not simply a matter of looking at the data to see the truth. Nor is it a matter of finding a negotiating space within which to reach a bargain.

I don’t frankly understand why it is necessary to have a panel of experts at all. The UCU should insist on the USS providing the figures that will permit a rounded picture of the likely evolution of the fund into the future. And there should be no detrimental changes to the contributions and benefits unless the necessity is clear from this picture.

March 21, 2018

Response to Urgent update from the USS trustees from member

The following response from a member was passed on to the UCU Pensions Officers discussion list by Sunil Banga

Dear USS,

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.[1] 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.[2] 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?[3] 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).”[4]

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

[1] Sean Coughlan, BBC News education and family correspondent, “University Pension Boss’s £82,000 Pay Rise,” http://www.bbc.co.uk/news/education-43157711.
[2] “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.
[3] https://twitter.com/JosephineCumbo/status/966205373349801985.
[4] 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.

Why some actuaries are getting pension schemes wrong

We have been told that many of the commentators on the USS crisis are behaving like 'amateur actuaries' who don't really understand what they are talking about. We need to be put straight by real actuaries. But actuaries are not all the same. Some of the comments that have been made by actuaries fail to address the central issues in the valuation. They are unthinkingly following the conventional wisdom that is enshrined in some of the relevant regulations. But because those regulations are wrong headed, being based on flawed financial economic theories, they miss the point.

The pension regulations, as they now stand, and as they are applied, expose schemes to much more risk than is warranted by the underlying economics. Pension schemes have to deal with it at great expense. It is a large component of their so-called deficit. This is particularly true of the funding rules that require mark-to-market accounting.

The reason is that the valuation methodology deals with capital values: it requires a comparison of the value of the investment portfolio at market prices, with the liabilities, capitalised by using some hypothetical assumptions.

But the truth is that pensions are cash flows. A pension is a monthly cash payment for life. That is quite different from a capital sum. Likewise the means to pay a pension is a flow of income, which is not at all the same as the market value of the fund's investment portfolio. Stocks and flows are fundamentally different concepts, a point that is drummed into every first year economics student.

A valuation of a pension scheme should be a simple question of whether, in the future, the income will be enough to pay the pensions. But that is not the way it is done. Comparing capital assets with capitalised liabilities is a proxy valuation using very noisy variables. This approach introduces risk in a big way because asset prices are excessively volatile.

The evidence - ignored by modern finance theory - is that the prices of assets, such as equities, real estate or bonds, tend to be far more volatile than the underlying income they yield, in dividends, rent or interest. Evidence from academic studies suggests that the measure of volatility of asset prices is roughly in the region of four times what it should theoretically be. Therein lies the source of much of the risk: the use of the wrong indicators.

And this effect is huge because it leads actuaries to use risk measures (probabilities obtained from the gaussian or normal distribution) calculated using standard deviations maybe four times too large. The valuation methodology that is so close to the heart of many actuaries today is flawed and its application has harmed the provision of pensions to millions of people. The USS is the latest in a long line of schemes that have suffered.

This argument, of course, assumes that the scheme continues open indefinitely, supported by its sponsor. It is different for schemes that are expected to lose their sponsor. They will need to be self sufficient and the value of the assets will be important in that they will have to be sold in the market to pay the pensions.

It is worrying that regulation seems to focus so much on the latter case. It would surely be much better for society if it promoted the continuance of pensions schemes as open to new members in the future.

Why has this situation come about? It is due to changes in thinking in the profession prompted by government. It is also due to changes in thinking about nature of the economy, in particular the increasing belief in the benefits of marketisation. The actuarial profession was criticised for various failings in the past which led to various enquiries, most significantly that by Sir Derek Morris, which reported in 2005, one of whose criticisms was: "an insular and inward looking approach to syllabus development in the past, with too few links with other academic disciplines and developments in academic actuarial science, which led the Profession to become out of touch with the latest thinking in other disciplines e.g. stochastic modelling and financial economics".

Financial economics is an ideal field of applicaiton of actuarial skills in statistical methods since it is an axiomatic system in which every financial asset is characterised simply in terms of metrics of risk and return, enabling the use of powerful tools to make statements about risk. But it is only a theoretical model, and can be shown that its assumptions are an oversimplification of reality. But it is such a beautiful model, and which produces such clear results, that it is hard for practitioners not to forget its weak empirical foundations. It is also too easy to apply it outside its zone of applicability. It is, for example, highly questionable whether it can be applied to the kind of analysis of the USS that are being discussed, simply because the scheme is so very large, that any changes to it would have macroeconomic and market changing effects. The measures of risk and return of different portfolios surely cannot be relied upon to hold over the major changes envisaged by such as Test 1, derisking etc. that are being discussed.

Financial economics has changed the way investment is regarded by its followers. It teaches that there is no long-term premium and all investment is merely short-term speculation with more or less risk. This is empirically rejected by very many studies but it is nonetheless maintained as a belief by many of those in positions of influence over the management of pensions.

Not only actuaries but government also has adopted the financial economics way of thinking. The Pensions Act 2004 brought in strict mark-to-market valuation which has had the unintended consequence of increasing the risk of schemes and led to many closures. There needs to be a rethink.

March 16, 2018

Reply to Sally Hunt

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.

January 25, 2018

Why the UUK proposals on USS pensions are mistaken

This is an opinion piece published in the Times Higher, https://tinyurl.com/ydfcr5zt (paywall) on 17 November 2017.

The USS pension scheme changes will be a disaster for universities; but they are preventable

The changes to the USS that UUK proposed on Friday will substantially alter the nature of academic employment in the Pre-92 universities and will damage higher education irrevocably. They will mean academic salaries having to rise substantially to attract the best both internationally and from other industries to maintain standards. As such, they are a very unwise, short-sighted – and unnecessary - move by the university employers.

The academic career in a leading institution is never easy. Research is fraught with hazards. However the certainty of a pension provides a safety net that facilitates risk taking. It permits a researcher, for example, to explore an avenue of enquiry, not knowing what if anything is there to be found, but always in the knowledge that if it turns out to be a blind alley – as is often the case - then at least he or she will not be personally worse off as a result. It is a good basis for intellectual risk taking on which progress in human knowledge comes.

So why are the UUK preparing to scrap the pension scheme that has worked so well and contributed to the success of British higher education? We are told it is all getting too risky and hence too expensive. But I don't think that is true.

Without going into technicalities, two things stand out, one political, one intellectual, as having created this fallacy. The political change was the coalition government’s withdrawal from formal involvement in the management of the scheme. Originally, when it started in 1975, there were three partners with seats on the board: the employers, the members and the government. At that time universities were mainly government financed through the University Grants Committee. The scheme had a strong covenant so could ignore any short term market volatility and invest long term in high return assets. But HEFCE withdrew in 2011, since when the institutions themselves have had to stand collectively behind the scheme. That is proving increasingly difficult given the uncertainties they are currently having to face. On the other hand, many commentators regard this particular group of well respected institutions as almost certainly sure to thrive for many years to come, and wonder what the fuss is about.

The other change that has led to this crisis has been in the mental framework used for pensions accounting in recent years. Most of the actuarial profession has undergone an epic ontological conversion from having a world view based on macroeconomics to one based on financial economics. Instead of pension schemes being able to benefit long term from economic growth by investing in productive capital, the traditional approach, they are now seen as myopic speculators in financial assets. Instead of investment return being the reward for patience, it is now seen as the reward for bearing risk; the world has become a “Random Walk Down Wall Street”; all assets are assumed to have a fixed quantum of risk which automatically and always gives a commensurate return. There is no distinction between long term and short term investment; all investment is speculation.

Financial economics has been widely adopted despite the fact that it is merely a theory without a sound basis: a pseudoscience. Many of its core ideas have been debunked by leading economists. For example the efficient markets hypothesis – that markets embody all known information - has been refuted by leading economists Joseph Stiglitz and Robert Shiller on theoretical and empirical grounds respectively.

Yet much of the finance industry including many pension scheme managers ignore the evidence. It is at the heart of the USS valuation methodology which talks about market derived asset prices, yield curves and inflation expectations being “objective”. But it is nothing more than a theory based on a particular set of assumptions.

It is a truly alarming state of affairs that such a closed belief system should be governing something as important and mundane as pensions. Yet universities themselves must ultimately take the blame. For the past twenty years or so business schools have found a ready market for financial economics courses. They have been marketed as “modern finance” embodying the latest research, with the emphasis on application of techniques rather than critically reviewing evidence, and have trained many thousands of graduates applying the ideas uncritically and confidently.

We are told there is a fixed amount of risk: the USS valuation document talks about a “risk budget”. Such a thing could only exist in the world according to financial economics. Risk depends on the context. There is a lot less risk if the scheme remains open to new members than if it may have to close. The view embodied in the USS valuation is the latter and that means market volatility poses a great risk that the pensions may not be paid and that has to be covered at great expense to the institutions. But if it remains open there is no need to regard market volatility as a problem and there is much less risk. In fact the UCU actuaries, First Actuarial, have demonstrated that the scheme could continue to invest in high return equities for the long term and all would be fine. Why are the UUK not listening?

November 23, 2017

Is the USS really in crisis?

Threat to the defined benefit pension scheme

The employers have said that they want to close the USS defined benefit pension (DB) scheme to future accrual, which means that new members will not be allowed to join, and existing members will not be able to contribute any more into it than they have already built up. Future pensions contributions will all go into a defined contribution (DC) pension pot via the Investment Builder.

Defined benefit pensions are much cheaper and less risky

This is a very bad decision because DB pensions are much better than DC ones. They are a guarantee of a secure 'wage' in retirement for life, whereas a DC pension scheme works differently: it gives a single sum of money on retirement which you have to turn into an income. And pension freedom puts you in the position of having to take some very serious decisions about what to do with this pot of money that will affect the rest of your life. A lot can go wrong, especially as a result of poor financial advice, and you may have to live out your retirement with the consequences of one bad decision.

A DC pension is risky because how much your 'pot' is worth depends on the vagaries of the stock market. Academic research has shown that it costs between fifty percent more and double to provide a given secure income in retirement via a DC pension scheme than than DB.

Essentially, there is less risk in a DB pension because of the collective nature of the scheme. None of us knows when we will die, which is the biggest risk facing us if we are having to live off a DC 'pot': if we do our 'drawdown' sums wrong we might run out of money before we die, or leave unused retirement money as an unplanned legacy if we die earlier than planned. (It is actually rather far fetched to believe we can plan for our retirement in this way.) But actuarial life expectancy tables solve this problem in a DB scheme: the longevity risk is simply pooled.

Likewise it is much less costly to build up a DB than a DC pension because the investments are pooled in a large diversified portfolio, exploiting economies of scale and the law of averages which are not available to a DC fund.

A pension is a 'wage' in retirement for life. A DB scheme is designed to provide that while a DC pension does not. A DC scheme is really an employer-subsidised saving scheme. How you turn the savings you have built up into a pension is another matter that you have to decide and that is not easy or cheap.

The source of the problem facing USS

Contrary to what a lot of people think, the USS is not a government scheme backed by the taxpayer, like the teachers, civil service, health service and others. It is a private scheme run and regulated like a company scheme. It comes under the Pensions Regulator in the same way as, for example the schemes at BT, Royal Mail, British Steel, BHS, etc. Like all these it is 'funded' which means, in effect, that it must stand on its own feet, that its trustees must be able to show the regulator that it will have enough funds to pay the pensions members have been promised and expect every month after they have reitred.

The source of all the controversy about valuing the scheme is the interpretation of the phrase 'enough funds to pay the pensions'. Does that mean a capital sum or a flow of income? The difference has a big effect on how much risk there is.

The UUK have said the scheme must close because it is in deficit, the deficit is growing and that is unsustainable because it means the institutions will have to make ever larger recovery payments.

Let us examine the claims of the UUK. First, the scheme is not in deficit in the ordinarily meaning of the term. Second, there is no evidence that investment returns are too low for the scheme to be sustainable. Third, the scheme is sustainable as long as it remains open and continues into the future along with the universities it serves. Fourth, it is highly questionable that there is a deficit even in the narrow technical meaning in which the word is being used here.

Where is the deficit?

Figure 1 (below) taken from the USS Annual Report for 2017 shows the income from contributions and investments and payments of benefits. It shows that there is not actually a deficit in the usual meaning of the word. Income from contributions by employers and members totals £2 bn, while pensions in payment come to £1.8 bn. In addition it made a return on its investment portfolio of £10 bn (mostly this was from market price movements but that figure includes over £1 billion in dividends, interest, rent etc).

We usually think of a deficit in the George Osborne sense of not enough money coming in to pay the outgoings, necessitating selling assets or borrowing more. The USS is clearly not in deficit. It is cash rich and every year investing its surplus in new assets such as Thames Water, Heathrow Airport, and many other infrastructure projects in addition to traditional assets like company shares and bonds.

 Figure 1: Deficit?

Figure 1: Is this what a deficit looks like?

Will there be a deficit in the Future? Here we must enter the realm of intellectual speculation and deal with economic theorising, market fundamentalism and evidence-free opinion

Looking at one year's figures is not enough since they may not be typical and we need to look into the future. We need to find a way of seeing if there will be enough money to pay the pensions when they come due.

It is not obvious how that can be implemented. We have to do a thought experiment.

Consider a pension payment to a young lecturer early in his or her career, when he or she has retired, say in 50 years from now. There has to be enough funds to pay that. The pension can be forecast on assumptions about longevity, salary growth, inflation and other factors. But how can we tell if will be enough money? One approach is to ask how much will be needed to be invested today to give enough in 50 years to pay the expected pension.

Since the trustees have to be sure that the money will be there, they must be prudent in their assumptions. How prudent is prudent enough? Since nothing is ever certain, if they wish to be very prudent, they cannot rely on contributions from employers or members in the future. Theoretically the scheme could close (maybe all the member institutions go under for some reason we do not yet know) and there could be no contributions. So it is arguably best to err on the safe side and make this assumption.

And they have to decide how the money is invested to pay the pension in 50 years. Since nothing is certain in investments it would be imprudent to rely on risky assets like equities, even though they are almost certain to grow handsomely in a long enough period. Prudence - paradoxically - requires investing in secure bonds, which have a poor rate of return. At the moment the rate of return on government bonds is at a record low level due to the government's policy of quantitative easing.

If we do this calculation for all prospective pension payments, we get a figure for the liabilities. Comparing that with the value of the assets the scheme owns gives the funding level or deficit/surplus.

The liabilities figure is very large because it is based on the very powerful arithmetic of compound interest over long periods of time. It is also very sensitive to assumptions made - for the same reason. And it must ignore a host of real world factors that can change dramatically. The figure for the deficit is very inaccurate and volatile since it is the difference between two very large numbers, the liabilities and the assets, both of which are highly volatile.The deficit figure quoted by the UUK and USS executive has changed by over £2billion in little over two months. This fact alone suggests that this way of valuing the scheme is unreliable: the actual value of the benefits can not have changed in that time by more than a miniscule amount.

Another other problem with this approach, that has not been sufficiently discussed, is that it begs the question of how the capital value of the assets is to be converted into money to pay the pensions - that is, an income stream. That process needs to be spelled out and not just assumed. Can a scheme as big as the USS just sell assets on a large scale if need be without disturbing the market? It seems unlikely.

Are investment returns really too poor?

The UUK give one of the reasons for the deficit that investment returns have fallen. It is certainly true that gilt rates are at the lowest they have ever been, lower than inflation. It would not really be sensible for a rational investor to invest in gilts since that would guarantee losing money. But other investments, particularly equities, produce a good return that would seem to be enough for the pension scheme to continue to be viable, if it continued to invest in them.

Figure 2 below shows the estimated returns on different investments that were prepared for the UCU by its actuary, First Actuarial. They contain a suitable margin for prudence to enable them to be the basis of a discount rate. The returns have fallen dramatically to low levels on bonds particularly government bonds.

  Figure 2: Poor investment returns?


Is the USS unsustainable?

Another thought experiment is to ask if there is likely to be enough cash flow to pay the pensions, based on a projection of income from contributions and investment earnings and liabilities. This is a natural, direct approach that requires less in the way of assumptions than the capitalisation approach described before. In particular it does not require a discount rate for compound interest calculation.

Figure 3, below, shows projected cash flows for the USS that have been prepared for the UCU union by its actuaries (First Actuarial). This is just one of a number of scenarios that have been studied but all show the same picture (2% real salary growth, real asset income of 0.2 percent). It is clear that from this point of view, where the scheme remains open indefinitely, in the same way as is highly likely the pre-92 university sector will, the pension scheme will be perfectly sustainable, having a small deficit or surplus.

 Figure 3: Unsustainable?

Figure 3

Is the scheme in technical deficit or is it in surplus?

There is a fundamental difference in the methodology between the situation where the scheme is assumed to be open indefinitely and where it is assumed to be getting prepared to close. In the latter case it must find a way of ensuring it is funded at all times, or at least as soon as possible while it can rely on the employer being able to support it. Volatility of the technical 'deficit' due to market fluctuations in asset prices represents risk here. The risk is that the scheme will close and the valuation will crystallise with assets values low due to a depressed market, such that they are inadequate to pay the liabilities. Hence the need for recovery payments to meet the cost of covering this risk.

On the other hand, if the scheme is open indefinitely with a strong covenant, it can be assumed it will never need to close. Therefore asset price volatility is not important. The ability of the scheme to pay benefits depends on there being sufficient investment and contribution income coming in. Therefore market volatility is not a source of risk. There is much less risk and therefore the scheme is cheaper because there is no need to cover it. Also the scheme does not need to invest in 'safe' assets like gilts for the same reason. An open scheme can, and should rationally, invest in assets that bring the highest return.

Figue 4 below (from the Technical Provisions Consultation document, September 2017) is the analysis, by the USS executive (not the UCU actuary this time, but the USS exectutive itself under its requirement to provide a fair view of the scheme), of the 'deficit' based on these two different assumptions. On the assumption that the scheme may have to close and therefore must be extremely prudent, so called 'gilts plus', which is the proposed basis, the 'deficit' is £5.1bn. (This has been changed since the TP document was published and is now £7.1 bn. The fact that these figures are so very volatile, with pension liabilities which change very slowly over decades being valued at amounts varying from month to month by billions calls into question the whole methodology.) On the other hand, if the scheme remains open, there is no need to apply a great layer of prudence to all the calculations, and the valuation of the liabilities can be done using the 'best estimate' of the investment returns as the discount rate. On this basis the scheme is massively in surplus, to the tune of £8.3bn!

Figure 4: 'Deficit' or 'Surplus'?

Figure 4

All the efforts of the scheme trustees, the employers and the Pensions Regulator should be devoted to ensuring the scheme remains open. The biggest risk comes from the deficit recovery payments calculated on the basis that the scheme might close. It is therefore a self-fulfilling prophecy. If the scheme is assumed to be ongoing and open then there is little risk.

Risk is not an absolute exogenous quantum as some suggest. It is contextual. And assumptions about it are self fulfilling. The problem with the methodology that is being used is that it is based on an assumption that risk is the same in all circumstances. That is a theory which is false empirically.

Why can't the Pension Protection Fund help?

What is puzzling is that the methodology takes no account of the safety net provided to all pension schemes by the Pension Protection Fund. The USS contributes its share of the levy to this government scheme which guarantees pensions in payment and ensures active members will receive pensions at 90 percent of the DB scheme level.

Why does the USS valuation ignore this? It seems directly relevant since it manifestly limits the risk.

It is said that if the USS entered the PPF it would be too big for it. But the PPF would take on the assets as well as the liabilities. Since the PPF is a government body there can be no problem of it failing to support the schemes in its portfolio, as there is with a private sector employer with a weak covenant. There is no problem with short term market volatility posing a risk.

Therefore we can argue that because the USS is protected by the PPF, a statutory body supported by government, the greatest part of its risk is removed. The valuation should therefore be done without such a large amount of prudence, and therefore the deficit will be much smaller or non-existent. Therefore the scheme is not in danger of failing and of having to enter the PPF.

Can anybody explain why this argument is not being used?

September 15, 2017

USS valuation: don't believe all you read in the press. USS is in good shape


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.

USS in Crisis? What is really going on? A message for all USS members.

This is the message sent to members of the USS from the UCU today.

USS in crisis? What’s really going on?

Academic staff in universities within the USS pension scheme have seen their pay fall in real terms since 2009, the cumulative loss to pay (compared to rises in RPI) is over 16%.

There are 53,237 academic staff at Pre 92 universities on fixed term contracts, many of them attempting to build a career.

In this context, the USS pension scheme is a vital and valued benefit for these staff, to some extent offsetting the pressure on pay and careers for these hard-pressed staff.

Since 2011, after 35 years of being a stable pension scheme, USS has been affected by great instability and turbulence.

Successive valuations in 2011 and 2014 have produced notional deficits that have been used to justify cuts to members’ pension benefits, with the closure of final salary pensions to new members in 2011 and then in 2014 the complete closure of final salary, together with the introduction of inferior Defined Contribution benefits for staff currently paid above £55,500.

In both cases, industrial action taken by UCU members staved off the introduction of significantly worse packages.

On 31st March 2017, the latest valuation of the USS scheme produced a notional deficit of £5 billion and the Trustee Board of the scheme indicated that to cover this, the cost of pensions need to be raised by 6 to 7%.

UCU is deeply concerned that if further cuts to pension benefits are proposed it will inject real long term risk into the USS scheme by making it increasingly less attractive to staff.

This is a real threat. USS faces the risk that it will become a decisively inferior package to the Teachers’ Pension Scheme, which staff in new ‘post-92 universities’ pay into. For example, a researcher joining USS at 38 with a 30 year career will receive more than £200,000 less in the USS scheme than they would in TPS over an average retirement.

The scheme is fundamentally sound

UCU argue that the USS scheme is fundamentally sound. Cash flows are positive. The sector is not likely to implode, the employer covenant is robust and the contributions from active members broadly cover pensions in payment. The scheme has £60 billion in assets to back up this situation. It is a ‘last man standing’ scheme where employers share the risk.

However, the way in which USS values the scheme is creating the appearance of a crisis which, the solution to which, ironically, threatens to generate a real long-term problem.

Since 2011, UCU has consistently argued that the USS ‘deficit’ is based on a flawed actuarial model. This model is creating an appearance of a scheme in crisis that then means it invests in more and more ‘safe assets’ which leads to lower returns then it is more expensive in effect a vicious circle.

Creating the appearance of crisis

The USS Board has opted for a valuation methodology based on a set of assumptions that UCU argue undervalues the robustness and unique nature of the USS scheme, which is one of the largest private sector schemes in the UK.

Most fundamentally, the Board has chosen to interpret the Pensions Regulator’s call for ‘prudence’ with unnecessary strictness by insisting on discounting the scheme’s liabilities using a complex measure termed Test 1 which is expressed in terms of the rate of return on government bonds rather than the rate of return on the scheme’s actual mix of assets.

As many commentators and pension experts have noted, this insistence on tying valuations to historically low gilts yields is creating artificially inflated deficits in many defined benefit pension schemes.

UUK is consulting the employers on the draft technical provisions which if accepted would lead to a watering down of benefits for scheme members. UCU argue that more confidence in the sector from employer and its ability to grow and support a decent pension scheme for staff would not only be important in retention but be valuable in recruiting world class academics.

UCU has commissioned its own actuarial analysis from First Actuarial, based on a different methodology, ‘Best Estimate minus’. ‘Best Estimate’ assumes that schemes will continue to pay out benefits as they fall due and make an actuarial best estimate of the future returns they will make on their actual investments, the minus is the introduction of prudence. We believe this methodology better reflects the reality of the sound fundamentals in the USS scheme and the UK higher education sector. Using this produces a surplus rather than a deficit in the scheme and obviates the need for the flawed ‘Technical Provisions’ being proposed.

At the very least, the fact that this is possible demonstrates the wildly different situations that can be generated by small changes in the assumptions being made by the Board.

Given what is at stake, we believe this makes it incumbent on the Board to reconsider this alternative approach in its valuation assumptions.


The approach being taken by the USS Board may be supported by the Pensions Regulator but the facts remain that:

  • their approach has been criticised by significant pensions experts who recognise that it is creating artificial deficits by linking asset values to historically low gilt yields;
  • their assumptions are based on a harsh, some might say ‘fantasy’ interpretation of prudence that does not reflect the real performance of actual USS assets;
  • the vision of ‘prudence’ is founded on a vision of the UK higher education sector suddenly shutting up shop overnight and winding itself up;

As a result of this, UK higher education employers who have cut staff pay consistently for years have taken fright and indicated they will not raise their contributions any further, leaving hard-pressed academic staff, vast numbers of whom are struggling to build careers on insecure contracts, to pay more or work longer to get a decent pension.

USS shows no sign of deviating from its chosen course and University employers show no sign of willingness to take on extra risk to cover the requirement for increased contributions that will inevitably follow.

Such a situation is highly likely to lead to significant industrial action in the UK higher education sector.

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