November 29, 2018

A question for the USS executive

I have put down the following question for the USS Institutions Meeting on 6 December.

"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?”


October 27, 2018

Pensions regulation based on mark–to–market valuation lacks transparency and overstates risk


Pensions regulation based on mark-to-market valuation lacks transparency and overstates risk*

(* This is a revised version of a presentation given at the CSFI Roundtable “Pension funding – more than an academic question” 27 September 2018, Wax Chandlers Hall, London.)

Although it is the largest in terms of assets and number of members, the University Superannuation Scheme (USS) is only the latest in a long line of private sector defined benefit pension schemes to be threatened with closure under the current system of regulation. USS members, of whom there are over 200,000 actively contributing[1], have seen through this and taken industrial action to challenge the valuation. They, being mainly academics, and, as such, disinclined to accept anything on trust, and to think things through from first principles for themselves, have questioned the methodology that would lead to this apparently well funded scheme being suddenly closed to DB accrual. The result of the industrial action has been the setting up of a high level enquiry under a panel of experts appointed jointly by the employers’ body, the UUK, and the members’ union, the UCU.

The Joint Expert Panel published its first report on 13 September 2018 commenting on the USS valuation dated at March 2017, which is the focus of the dispute and has not yet been completed. It is quite critical of some of the actions of the employers, the scheme management and also the regulator. The panel is due to continue its work into a second stage to look more fundamentally at the regulatory methodology, particularly as it applies to the university sector[2].

I am not going to discuss the USS dispute or the JEP report here in detail[3]. That would be a good subject for another CSFI round table which I hope can be organized soon.

I will argue instead more generally that our poorly designed regulation system[4] is a policy mistake on a grand scale. Specifically by prioritising the statutory funding objective, which is supposed to ensure every scheme has enough assets to cover its technical provisions, it fails to give a clear picture of the health of an open pension scheme, and is problematic in two ways. First it is not transparent, because it focuses on a poor indicator. Second, and worse, it greatly exaggerates risk, that has to be dealt with at great cost. I will argue against this monistic approach and for economic pluralism in the monitoring of pension schemes, looking at them in the round, using a range of criteria, not simply balance sheet valuations of assets and liabilities on a mark-to-market basis at a moment in time.

I will also argue that an effect of the regulatory system is to allow circular reasoning where the assumptions that are made in valuing liabilities are self-fulfilling. Pessimistic assumptions lead to negative outcomes. Schemes end up being forced to close as a result of over-prudent assumptions.

A third important line of criticism of the current regulatory regime, that is often ignored, is that, besides limiting pensions provision for millions of people, with consequent erosion of the social fabric due to poor support for the elderly, it is also doing substantial macroeconomic damage, hampering economic growth. I will show that this is the result of the adoption of false economic theories over empirical evidence.

Full paper here






[1] The scheme also has approximately 70,000 retired, and 150.000 deferred members.

[2] It is important to understand that the USS is the pension scheme covering only the so-called pre-92 universities and associated institutions, including Oxbridge, the Scottish ancient universities, the London colleges, the Civics and the 1960s generation of New Universities. In the main they all have a substantial commitment to research as well as teaching at both undergraduate and postgraduate levels, and many are among the leading universities worldwide. The new universities that have been created by the Thatcher government and subsequently are not USS institutions. Since historically most of them were formerly polytechnics or other kinds of colleges in the local government sector, their staff are members of the Teachers Pension Scheme, which is an unfunded government scheme. It has been remarked that if the proposed changes to USS go through, and it closes to DB accrual, pension benefits will be better at Oxford Brookes than Oxford, Anglia Ruskin than Cambridge, Teesside than Durham.

[3] The terms of reference and the first Report of the Joint Expert Panel can be downloaded from http://www.ussjep.org.uk

[4] Dating largely from the Pensions Act 2004 that created the Pensions Regulator and Pension Protection Fund, and regulations subsequently applied by the regulator.


August 17, 2018

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

Evidence to the Joint Expert Panel

by

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Inconsistent idea of risk

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

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

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

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

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

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

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

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

References

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

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

USS, Draft 2017 Actuarial Valuation, 1 September 2017.



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

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


June 25, 2018

Pensions: A sustainable social contract

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

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

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

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


June 20, 2018

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

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

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

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


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

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

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

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

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

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

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

Return to surpluses is possible

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

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

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


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

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

Time for the IFoA and PLSA to act

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

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

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

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

May 02, 2018

Being actuarial with the truth

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


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

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

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

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


April 30, 2018

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

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

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

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

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

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


Issues for the JEP agenda


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


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

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

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


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


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

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

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


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


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



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

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



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

Members should ask for further detailed information as follows: 


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



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


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


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


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


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


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



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



USS Directors and their Remuneration

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

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

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

screen_shot_2018-04-27_at_131735.png



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

executive pay

salaries


April 17, 2018

The advantages of an open pension scheme

Writing about web page USS; pensions

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

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


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


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


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

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


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


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


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

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


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