December 11, 2023

New paper on the economics of DB pensions with reference to the USS

I wrote this paper for the recent Event organised by Sir John Kay on risk and uncertainty in pensions under the auspices of the CISI. This was a half-day conference in October with the title `Risk and uncertainty in the pensions world: correcting the biggest avoidable UK public policy failure of recent decades'. Its theme was that the attempt to manage uncertainty by the use of risk models and financial economics has been disastrous for pensions. It included a session on the USS which is a defined benefit scheme open to new members which has seen its valuation go from a deficit of £14.1billion in 2020 to a surplus of £7.1 billion in 2023.

 



Pension scheme valuation versus funding pensions: the limits of financial economics and the Universities Superannuation Scheme


Abstract

A valuation of a pension scheme is not the same as funding of its pensions, except under the strict conditions assumed by financial economics. The introduction of regulation based on valuation using techniques of financial economics has made many schemes appear unstable or unaffordable and many have closed. USS illustrates the problems, having swung round from having a large deficit at the 2020 valuation to a surplus in 2023. As a scheme, for the important university sector, that is open to new members, with multiple employers and strong covenant, its pensions are well funded yet in recent years the valuation methodology has suggested otherwise. Its existence as a defined benefit scheme has been threatened due to overuse of methods from financial economics to manage risk. It would be better to focus on funding as the key issue. Uncertainty about the future should be resolved by informed judgement rather than pretending it is risk to be managed using financial models. The paper makes concrete proposals to improve USS funding.

Download the paper

April 03, 2023

Comments on the USS valuation

There is a lot more involved in the USS dispute than what the level of gilt rates is on 31 March. Actually focusing on itgets in the way of understanding the true situation which is much more nuanced.

The idea that the market interest rate on government bonds - that fluctuates daily, with stock market movements - somehow matters to the pensions members will draw in two, three, four decades time is akin to a belief in magic.

The valuation (that compares assets and liabilities on a given date) is not the pension. It is not ‘counting the beans’ as many people seem to think. It is not an objective procedure. It is contextual.

The valuation is a statutory solvency check designed for those schemes that need to sell assets to pay pensions, usually company schemes closed to new members. USS is not one of those. It does not need to sell assets. So the context for USS is different; for it the valuation is really little more than a formality to comply with the rules.

The context of the valuation (and the regulatory code generally) is one that premises ultimate closure which results in higher perception of risk and greater cost of prudence. A scheme like USS, open with a strong employer covenant and a stream of new joiners, is in a very different situation as regards prudent funding and investment opportunities. That should lead our thinking.

The true funding situation is actually much better. It is not only that the extremely low interest rates of the past twelve years of QE are now back at a more normal level which has sent many pension schemes into surplus.

We should not be satisfied with that. There is a lot more that we should be demanding. We should STILL be challenging the valuation methodology.

The news about the USS is undeniably good. UUK have agreed to reinstate benefits in principle and USS have confirmed that should be possible given the surplus. But there are not just two parties involved in the dispute. Besides UUK and UCU there is the USS who manage the investments and do the valuation sums according to their own beliefs. And behind them there is the government in the shape of the DWP and Pensions Regulator who set the rules for DB pensions.

So it is possible UUK negotiators may not be able to deliver on everything they want (even if they speak for all their institutional members). Our main concern should be the context in which USS invests and does the valuation which to date has been a widely held conviction among actuaries, regulators, accountants, consultants, scheme investors that assumes the ultimate closure of DB schemes. So there is still a battle of ideas to be fought both with the USS executive and also with the DWP/Regulator.

What is really encouraging however is not only the joint letter from UUK/UCU/USS to the Regulator but also the USS response to the Regulator’s latest consultation on the Draft Code in which they make it absolutely clear that the scheme should be allowed to be runon the basis that it will remain open for decades to come. Supporting this means widening campaigning for university pensions to the parliamentary sphere, enlisting support from MPs and peers for the principle of keeping Defined Benefits pensions open.

There is also a need to keep up the pressure on the USS executive to change the assumptions that determine how they see risk in the valuation. At present liabilities are inflated enormously because market risk is (incorrectly) modelled in terms of stock market volatility,giving rise to the need to build in excessive prudence to hedge it, hugely bloating the liabilities figure. Capital exhaustion simulations are far too pessimistic. There is also the little matter of LDI. And many assumptions that go into the valuation assume closure (for example the key concept of self sufficiency). So there is need for a culture change in the USS executive.

But if the scheme is seen as open indefinitely, with a strong employer covenant, it does not need to worry unduly about asset price excess volatility. Risk it needs to worry about is in the future cash flows from contributions and investment receipts that fund the pensions. So the cost of prudence is far lower.

We are winning the argument. But it would be premature to think it is won.


March 22, 2023

USS and Capital Exhaustion

Con Keating

Shortly after it was published in early March by USS, I was asked to review their note “USS briefing: Capital funding and exhaustion risk – distribution of outcomes”. The stated reason for it was: “This briefing note provides details of analysis, requested by members of the Joint Negotiating Committee (JNC), of the risk of the scheme running out of funds before all benefits due to members have been paid.”

The study had however already been in existence for rather a long time as can be understood from this paragraph in the summary of the Valuation Technical Forum (VTF) of November 17th, which states:

Capital exhaustion

A broad overview was given on this analysis for the forum and what it was looking to consider (i.e., a metric that is looking to test what failure may actually mean as measured by the risk of running out of money to pay benefits). Within the discussion it was agreed that the analysis to date which had been prepared for and discussed with stakeholders be made available on the USS website. It was agreed this would be taken forward.”

It is interesting that there have been three and perhaps four meetings of the VTF since then but no summaries of those have been published. I am not sure if we are missing anything by that non-publication given the summary’s ability to tell us little or nothing of substance, as is illustrated below:

FMP report to 30 September 2022 (including a discussion on 30 Sept pricing modelling) It was noted that the direction of travel shown in the monitoring continued to be a positive indicator for the 2023 valuation. There was a discussion on self-sufficiency and what other measures could potentially be used to demonstrate the solvency position over time of the scheme. There was brief discussion on inflation which identified the need to understand just how impactful it would be on the valuation outcomes before engaging in a detailed discussion.”

It happens that I have difficulty believing the reported September and December asset portfolio valuations, but this leaves me none the wiser.

Though some of the VTF summary is written in a code unavailable to the uninitiated, such as: “UCU and UUK expressed their desire to have as solid a basis as possible to consider in February, in advance of the 31 March date, and there was a discussion about the art of the possible from the Trustee’s perspective including the sensitivities and book ends that could be provided to the Forum.”, it is clear that the executive’s objective is developing this model was to produce “a metric that is looking to test what failure may actually mean as measured by the risk of running out of money to pay benefits”.

Unfortunately, this modelling approach, which is based on the model developed in their NIESR papers by Miles and Sefton[i], is not fit for that purpose. The software used to produce the published results is produced by Ortec Finance. It is also a total return-based system.

The briefing note is unscientific in that it is not possible to reproduce its results from the information provided in it. This occurs so often in USS publications that one is tempted to wonder if it is deliberate policy. It is though possible to identify, by comparison, some minor anomalies and inconsistencies in the reproduced charts arising from it. One of the more egregious absences is that there is no statement of the statistical properties of the elements of the model, for example the volatilities of the asset classes comprising the portfolio. In a stochastic model, these are crucial.

This is alarming given that “The Trustee is currently considering how, alongside other risk metrics and the wider integrated risk management framework, these outputs might inform future decisions in relation to the valuation investment strategy.”

The central problem is that it deducts the projected pension payments from the stochastically generated asset portfolio as that develops over time, using the returns and volatilities of those asset categories. This can generate some rather strange results as can be illustrated in a very simple model I developed in Excel to illustrate this point. This is available on request.

Mathematically we expect the geometric return of a series of normally distributed returns to be equal to the arithmetic return of that series minus half the variance of those returns. This means that we expect the geometric return, the long run average return, to be similar, at 5.0%, for two series, one distributed N(7%,20%) and one N(5.5%, 10%) but this is not the case. In simulations, we can see the consequence of this, for the N(7,20) case we see ca 650 iterations survive and pay all pensions, the earliest failures occur around year 6 and the average survival time is around 60 years. By contrast, the N(5.5, 10) returns over 800 complete survivals, with the earliest failures occurring around year 16, and the average survival time is extended to around 71 years.

It is clear that in such models, volatility is heavily penalised. This is simply recognition that sale of some fixed amount of an asset is more onerous when that asset is depressed in price than when it is inflated, and the magnitude of those effects is directly related to the range or volatility of the asset value.

This approach to modelling will also deliver exaggerated levels of over-funding, as seen clearly in the USS briefing note charts.

In any event, such an asset only based model, where all pensions are paid by sale of assets is completely unrealistic. Pensions are paid in cash and income in critical in this context. If the dividend and investment income stream is sufficient to pay pensions, exhaustion of capital resources can only come about from the price randomness of the asset portfolio. As this is the most important point in this blog, I shall reiterate it. Crudely put, if the dividend and investment income stream is sufficient to pay pensions, then capital resources are not being touched and won't be exhausted, barring very large numbers of insolvencies, defaults and exceptional situations.

The "if" is important! It is easy to achieve in an open scheme if contributions are added to the income, harder to achieve in a closed scheme.

It should be noted that the variability of income is a fraction of that of market price – a long used heuristic is that equity prices are five times as variable as their dividends. The variability of income from bonds is lower still, indeed bond income may almost be considered deterministic, that is fixed by the terms of the security and the price paid. In addition to this, there is the cash flow from the maturing proceeds of bonds to be considered as this cash flow will also reduce the scheme’s dependence on sales of other assets to pay pensions.

The likelihood of scheme failure is far lower than suggested by these asset-based models. Indeed, they simply bear no resemblance to the observed history of DB schemes, nothing like 17.9% of schemes have exhausted all of their capital resources in the entire UK history of pension schemes. Indeed, I struggled to find any since 1921, let alone the past 60 years.

It is also interesting to note that the lower rates of exhaustion associated with the deficit repair contributions of the model are an implicit recognition of the importance of cash inflows. A 6.1% failure rate falls to 0.0% at 30 years with 10% deficit repair contributions.

Those contributions are described as 10% of the membership payrolls but I do not know how large that is, and the briefing note does not tell us[ii]. My guess would be around £9 billion, given the published higher education statistics. That contribution would represent some 35% - 40% of the pensions payable, around 1.25% in income yield terms.

It is the income aspect of the contributions for new awards which adds to the attractions and efficiency of open rather than closed schemes. Indeed, if the scheme is cash flow positive, that is investment income and new awards are greater than current pensions payable, the scheme will prefer lower prices and their higher potential returns to the high prices preferred by a closed scheme in run-off.

I will end this blog by touching on the question of leverage in schemes. As has been noted elsewhere, this can place significant demands on the liquidity of schemes, that is their cash available to pay pensions and that could have catastrophic effects, a slow-motion car crash.

It is absolutely clear that this USS model is not in any way fit for the purpose stated.



[ii]Since writing this, I have been directed to the 2020 valuation which reports active membership payroll as £8,962 million.


March 18, 2023

A critical note on USS valuation methodology

I was appointed as a UCU observer to the Valuation Technical Forum, a high level discussion group considering technical aspects of the 2023 valuation. Its membership includes representatives from UUK, UCU, USS trustees, USS executive, and their actuarial advisers.

I wrote up some comments and submitted them to the other members of the Forum. Here is the l ink.


a_critical_note_on_uss_valuation_methodology.pdf


March 10, 2023

David Miles' Response

Follow-up to Miles and Sefton on USS capital exhaustion from Dennis Leech's blog

Dear Dennis

Thanks for your comments on the various notes James Sefton and I wrote in 2021.

You make two main points: First, in our simulations we look at how the USS finances might evolve in the absence of new contributions and with liabilities (accrued pension rights) taken at some point. Second, we assume that pensions are paid out of the existing assets with a constant portfolio allocation. The evolution of that stock of assets depends on the return (investment income generated plus the capital gain or loss on the assets) net of pensions paid.

In practice the USS is still open – though in some sense its openness is declining because more new pension accruals and inflows will be significantly into a DC fund and perhaps because the rate at which younger academics join the DB scheme looks likely to be less than that of earlier cohorts.

What seems likely is that whether the scheme gets new DB members depends on the deal they are offered and that deal will be more or less attractive depending on whether there are enough assets to pay existing pension liabilities that exist as time passes. This means that to assume the scheme continues to have a steady flow of new DB members joining and that existing members can have pensions paid out of new contributions (as well as from investment income) certainly understates the extent of inter-generational risk sharing. The more existing pensions are paid out of new contributions which are in excess of what is needed to match the present value of new liabilities the worse a deal is offered to active members and the less likely that they remain active.

Our calculations ask a question about whether existing liabilities are such that they can be paid in full out of existing assets. It calculates the probability that they can and – in cases where those assets are more or less than is needed to pay existing pension promises - what is the size of the ultimate deficit or surplus. The calculated probability of running out of money before existing pension liabilities are paid is the probability that future employees or employers will have to make good the hole. If this comes from future active members it will means the present value of extra pensions they get from their contributions are lower than the money they put in. That seems likely to make new members look elsewhere. That generates a risk . Our calculations calibrate the scale of that risk.

You are right that if equities display significant mean reversion – which I think you implicitly assume – then an assumption of independent returns will exaggerate risk. This is why we did simulations with a degree of mean reversion that some studies suggest might exist.

All best

David

David Miles, CBE

Professor of Financial Economics

Imperial College

South Kensington Campus, London SW7 2AZ

T: +44 (0)207 594 1292

Web page: http://www.imperial.ac.uk/people/d.miles


Miles and Sefton on USS capital exhaustion

Writing about web page https://www.niesr.ac.uk/publications/how-much-risk-uss-taking?type=policy-papers

Commentson the paper “How much risk is the USS taking?” by David Miles and James Sefton

The paper addresses the question posed in the title using stochastic simulations to model the likelihood of the scheme’s capital assets becoming exhausted. In this note I argue that the method they adopt, in particular their specific chosen stochastic model, is not a reliable basis for making such a judgment because it exaggerates risk.

It is crucial to understanding whether a pension scheme has “enough money”, to be clear about what that would mean in practice, what assumptions are being made about the progress of the scheme over time, and what kind of money is needed anyway. Thus any stochastic modelling that tries to answer that question should distinguish between, on the one hand, the market valueof the investment assets and, on the other, the investment incomethose investments bring in. These are not equivalent and which is more relevant depends on the framing of the question.

If the scheme is being considered for possible closure, the former view is important, since one must have regard to runoff, where assets are sold to pay pensions as the beneficiaries dwindle. But if it is being seen as possibly able to continue open indefinitely, with the support of a strong employer covenant and a steady influx of new members, then the latter perspective is required since asset sale is not the primary concern. It is important that trustees carry out analyses from both points of view, which are not equivalent.

Miles and Sefton fail to make this distinction. Instead their approach is simply to model the time path of total returns, running together investment income and capital gains/losses - whether realised or not. This means that, from the point of view of answering the question whether the scheme can remain open sustainably, their simulations overstate risk and their conclusions are overly pessimistic. Their stochastic model allows in, and bakes in, too much variation coming from excessively volatile asset markets, whether stock, bond, real estate markets.

Risk will also be overstated as a result of using percentage yields(%)instead of cash income(£)as the random element. Yield expressed as a percentage is inherently excessively volatile because market prices appear in the denominator. On the other hand, absolute investment income in money terms is driven by real economic factors and much less susceptible to this volatility.4

The paper’s basic idea is that the investment portfolio can be seen as comprising two classes of assets: ‘risky’ equities, which produce a high return on average but one that is also highly variable, and ‘safe’ bonds, with a low but fairly constant return. The question is essentially whether the equity returns, on average, are sufficiently high to outweigh the combined effects of the low bond yield and that the likelihood of the equity returns underperforming by too much.

It uses a simple model applied to actual USS data starting from the assets at the 2020 valuation, £66.5 billion. and the projected cash flow of pension payments each year up to 2102 by when all accrued benefits will have been paid.

Their conclusion is that, while on average the scheme is well enough funded that it will be able to pay all the pensions promises, there is still a significant probability that the money will run out and the scheme will be unable to pay the promised pension benefits without needing to ask the employers for further contributions. This probability is of the order of over 30 percent for a portfolio with a majority of growth assets. These findings are worrying.

The paper addresses a straightforward empirical question that turns mainly on the relative risk and return parameters of the two asset classes. However there are a number of major issues with this study that may well point to different conclusions emerging if addressed. Most importantly there is an important, basic, methodological issue unaddressed: the relation between asset prices and pensions funding for the USS, with its unique characteristics as a very large, open, immature, multi-employer scheme.

Detailed Comments

1. The methodology employed is questionable because it focuses solely on asset valuesrather than specifically on pension funding, which is likely to lead to an overstatement of risk and therefore biased findings. It examines the likelihood (as a probability estimated in a Monte-Carlo simulation) that the assets will become exhausted - not the likelihood that not all the projected pensions will be paid, without further funding. These two questions are not the same and the difference is crucially important to the stochastic modelling: the former methodology focuses on the market value of the investment portfolio where the randomness mainly comes from the stock market through prices. For the latter methodology, asset values are not of primary concern, since the scheme will only need to sell capital to pay pensions whenever there is a shortfall in income. The study should therefore model the probability of such a shortfall separately.

By ignoring this distinction Miles and Sefton are implicitly making an unreal assumption that is actually key to their results. They end up using an inappropriate risk metric for determining funding - in all circumstances whether the scheme needs to sell assets to pay pensions or not - related to the excess volatility of stock market prices. It would surely be more relevant to use a measure of variation in investment income, that is cash receipts, which is known to be much less volatile, since it is mostly independent of the animal spirits, irrational exuberance, booms and busts, etc to which the stock market is prone. When talking about risk it is necessary to study the second moments of the probability distributions but also to be clear about the metric: are we looking at randomness of capital values or investment receipts?

continue reading


January 28, 2021

Pension scheme valuation versus pension funding and the cost of prudence (with reference to USS)

My argument in this latest draft of my paper on pensions valuation and funding (pensionsvaluation5.pdf) is relevant to all defined benefit schemes, of which there are still over 5300. It is aimed primarily at the regulator, who is faced with a siituaton of worsening deficits, and secondly at the actuarial profession. It is also directed at all who are involved in the valuation of the University Superannuation Scheme, whether executive, directors or the stakeholders UCU or UUK.

According to the latest Purple Book published by the Pension Protection Fund, total combine deficits of all DB pension schemes as at March 2020, have reached £90.7 billion last year compared with £12.7 billion the year before. This is before the effects of covid-19 have been felt and more and more schemes have to depend on the PPF.

The pensions crisis, that has been getting worse for a number of years, and has led to many schemes closing to new accrual, is exacerbated by a regulatory system requiring market price valuations, combined with very low gilt rates (due to government monetary policy/ quantitative easing) used to calculate liabilities. But this is not the only methodology that can be used: it is aimed at ensuring schemes with weak employer support have enough assets they can liquidate to pay the pensions should they have to close. But for an open scheme with a strong employer covenant it is very misleading and leads to cost increases that undermine it. For an open scheme it is better to make a direct analysis of funding needs comparing projected investment earnings with benefit outgo (something that actuaries did in the past).

Where there is a very large and significant difference between the se two methodologies is in the risk metric that determines the cost of prudence. The mark-to-market methodology must use a very much greater risk allowance - due to the much greater volatility of asset market prices as compared with investment earnings. This means that the regulatory system we are using artificially inflates the cost of prudence. It contains a serious bias that makes schemes appear much more expensive, and deficits much bigger, than would be the case if they were valued as open schemes.

This is a serious issue for the USS which has so far stuck religiously with the mark-to-market methodology despite it being an open scheme with a strong multi-employer covenant. Stakeholders should demand a re-appraisal using the traditional actuarial methodology before reaching any conclusions about the future of the scheme.


December 11, 2020

USS Governance: Changes to the Articles of Associaiton of the trustee company

There is a lot of discussion just now on how the Universities Superannuation Scheme is governed. Here is a paper I wrote last year commenting on the changes then being made to the rules for appointing directors. It may be of interest but some of it could be outdated by now in light of other changes.

uss_articles_recent_changes.pdf


August 26, 2019

The USS dispute is not about cost sharing but the survival of defined benefit pensions: a rejoinder

What is at stake in the USS dispute is the survival of defined benefit pensions.

The UCU negotiators have repeatedly shown that there is no need for contribution increases or benefit cuts, that the scheme as it currently exists can continue in existence indefinitely provided it is managed in a way that seeks to make that happen. The reason is that it is a multi-employer scheme designed for a unique sector, the pre-92 universities. The pre-92 universities not only provide world class scholarship, research and education but, as a sector, can be seen as one of the UK’s most successful industries. That should be at the front and centre of all discussions about the USS: its unique nature means it has very little in common with other private sector schemes and should not therefore be compared with them.

Unfortunately the USS Employers in their latest response to the UCU have demonstrated that they are not engaging with that view and give no indication of their intention to do so. Their letter is full of innuendo and half-truth and does not deal with the arguments. It underestimates the intelligence of university staff and many will feel insulted and devalued by it.

The choice for the USS is between two possible alternative courses:

(1) that it continues to be an open ‘defined benefit’ scheme that provides guaranteed pensions based on salary and years of service, on an ongoing basis with an indefinite time horizon, open to new members, supported by a strong employer covenant that is continuously monitored; or

(2) that, in common with most private sector company schemes, it may decide that the various risks of staying open are too great, and do what they have done, close to further accrual, with consequent increases in contribution rates, as was proposed last year. New members will be offered an inferior ‘defined contribution’ plan that does not lead directly to a solid pension but uncertain benefits. Employers will take advantage of this change to cut their contributions as well as transferring all the risk.

These two alternatives require the scheme to be viewed in different ways that lead to different investment strategies and different ways of managing risk. And two different valuations. Any decision about the future of the scheme requires a comparison of both.

If the scheme is assumed to remain open, as in alternative (1), providing that there is positive cash flow available for long term investment, in a suitably diversified portfolio that includes high return assets such as equities, there will be healthy income to pay pensions in the future. The main source of investment risk - short term asset price volatility - can be managed. Since the pension payments are long in the future, it is long term investment returns that matter, and short term volatility can be ignored.

In fact in an open ongoing scheme that is cash flow positive like the USS, any downturn in the stock market is an advantage, not a threat - because it means assets can then be purchased more cheaply, reducing the cost of future service accrual.

The valuation of an open scheme ideally requires a comparison of projected income flows with projected outgo in pension payments. The UCU have repeatedly asked the USS to carry out such an analysis without one having yet been published. Our actuarial advisor First Actuarial have provided such analysis that strongly points to the scheme being sustainable. It would be good if the UUK joined us in demanding the USS carry out a similar analysis using the complete data set that they have available.

Alternative (1), of course, depends on there being a strong employer covenant. The covenant risk to the scheme is essentially the insolvency of all the pre-92 universities. The risk from insolvency of individual institutions is offset by the collective nature of the scheme, so called ‘last man standing’. The risks facing the scheme are essentially those facing the pre-92 higher education ‘market’ as a whole. That does not seem a likely prospect at the moment. If that begins to change it will be noticed in the periodic review of the scheme and in the triennial valuations. It does not seem realistic to assume it will happen suddenly without warning.

Alternative (2) is the only one that the USS employers, executive and most of the trustees seem to be willing to countenance. It denies the unique nature of the USS as a sector scheme and treats it as if it were a mature single employer scheme. It assumes the scheme matures and then the job of the trustees is to manage the ensuing runoff. The whole emphasis is on risk rather than return, making sure the invested funds can pay the pension promises with absolute certainty. Paying the pensions depends on the investments being risk-free which means investing in government bonds.

The problem - and the source of the dispute - is that government bonds are no longer a good investment. Twenty years ago they would have produced a return of perhaps 2% above inflation but today, thanks to post-crisis monetary policy and quantitative easing by the Bank of England, the rate of return after inflation is negative.

Yet the policy of the USS, supported by the UUK employers, ignoring the thinking of the Joint Expert Panel, of so-called de-risking, is to invest in assets that are guaranteed to lose money. This is regarded as a low risk strategy on the grounds that the loss is certain. This is surely an absurdity. De-risking actually increases the risk to the scheme that it cannot pay the pensions when they fall due because the loss on the gilts has to be paid for by the members and employers. This is what is driving up contributions and threatens the survival of the scheme.

It should be noted also that interest rates on government bonds are no indication of investment returns more generally. The expected long term return on equities and other forms of patient investment in the productive economy (rather than lending to the government) continues to be sufficiently high to pay the benefits.

Essentially the defined benefit scheme is being undermined by the herd mentality group think of the pensions experts in the USS executive. They are applying thinking from the past - when it was rational for pension schemes to invest in government bonds that produced a steady though modest return as part of its risk management - to today’s conditions of negative risk-free rates. It is an example of how real damage to people’s welfare can result from the continued unreflective use of an economic model when the conditions for its application do not hold or have changed.



December 17, 2018

USS Institutions Meeting very disappointing

Last week was the annual USS Institutions Meeting, an opportunity for employers to be updated about the state of the pension scheme.

I attended as an elected member-nominated rep on the Advisory Committee (part of the formal USS governance structure). Attendees were invited to submit a question. I was disappointed that mine was not addressed but instead a heavily edited version substituted - and even that was not fully answered. My question was addressed to the chief executive, Bill Galvin, but the substitute question was answered by the actuary.

At bottom the issue facing the USS and the focus of the dispute is intellectual: a matter of methodology. A pension scheme must have sufficient funding to cover its liabilities when they fail due to be paid. That is obvious but there are different ways of assessing a scheme's ability to fund its pension payments over the years. However the law only requires the trustees to report on one of them, the Statutory Funding Objective, which requires the assets must be at least equal to the actuarial valuation of the liabilities known as the technical provisions, otherwise there is a deficit that must be filled by a recovery plan.

The actuarial profession is not united that this method - valuation - is necessarily the right approach and that it may be problematic. Many actuaries instead advocate projecting the flow of income - from both contributions and investments - to see if it will cover the flow of future benefits. I wanted to cite an important reference critiquing the valuation method: the paper by Simon Carne, which shows that the projection method is perfectly rigorous.

I wanted to show that it makes perfect sense to use both methods to get a rounded view. And Bill Galvin had previously accepted the point when I had asked a similar question two years ago. But it was evident that the the USS executive and the board are committed to one and only one valuation.

Here is my question:

The USS seems to be wedded to a single approach to funding via valuation, using ideas from financial economics. But that is not the only one. Another, equally valid method is available: the budgeting approach traditionally used by actuaries based on projected income and outgo. Simon Carne, in his seminal paper “Being Actuarial with the Truth”, showed this method to be perfectly rigorous and most of the claims of financial economists against it to be false. For a scheme with a strong covenant like the USS it has the advantage of avoiding the use of volatile asset prices and problematic discount rates.

It answers the question: by how much is the pension fund in surplus or deficit on the premise that the existing investment strategy is maintained, with all future reinvestment following the current investment strategy? It would be useful for the USS to know the answer to that question, in addition to the valuation. This method - which does not depend on discount rates driven down by the artificialities of the government’s quantitative easing policy, nor the market risk introduced by excessive asset price volatility - has been advocated by First Actuarial and applied to many schemes, including USS, showing only small deficits or surpluses.

At this meeting two years ago I asked if you would use this approach as a supplement to the statutory valuation. Bill Galvin replied: “Triangulation of different approaches is very much part of our first principles approach, with the use of a number of different lenses rather than a single lens; then we are very open to that as well.”

Can I please ask that you report the results of using this approach to determine the level of funding?”

Here is the question that was put to the scheme actuary, who was easily able to dismiss the suggestion of an alternative approach. It did not seem from his answer that he had seen the original question.

Here is the edited version

This illustrates a great weakness of the current management of the USS: that it fails to engage with the intellectual arguments surrounding pensions. Since the USS is the pension scheme for universities, it might be expected that the trustees, most of whom are academics, would be keenly interested in the arguments about actuarial practice and financial economics that have been going on for over twenty years, in order to try to get a better understanding. But no, they seem to want to manage the scheme as if there is nothing to question about the methodology, and their job consists in little more than unthinkingly applying the rules designed essentially for small commercial companies. It is unfortunate that academics and others who are thinking about these crucial methodological questions are not being taken seriously by the management. It is hard to avoid the conclusion that the USS has become a scheme FOR universities rather than a true university scheme.


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