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?

fig2.png


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

USSlogo


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.

Summary

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.


August 11, 2017

More analysis of the USS 'deficit'

There has been some press coverage of the latest annual report of the USS (for the year up to 31 March 2017). It shows a substantial 'monitoring deficit'. This deficit is larger than last year which has led some to make sensational claims about the scheme needing to cut benefits or increase contributions from employers and/or members.

The real issue is whether we take the deficit as gospel truth or not. Some, such as the head of the employers pensions forum, Professor Koen Lambers, VC of York, accept it uncritically as factual. Others, however, are more sceptical, pointing out that it is a result of the falling interest rate on government bonds or gilts, that has been engineered alongside the 'quantitative easing' policy to try and stimulate the economy. This clearly does not have any effect on pensions either now or in the future, which are defined parametrically by the rules of the scheme: pensions depend on number of years of service and average salary (up to £55k). Gilts rates have no effect on either pensions or the ability of the scheme to finance those pensions through their investment income and contributions.

The debate about the USS is directly related to the wider national debate going on, led by the DWP, about how pension schemes should be valued and whether they are sustainable. Comments have been published here. The two issues should be taken together - not least because the USS is the largest scheme in the system - but some commentators are ignoring the national debate. What is needed is an open debate about the USS that includes pensions experts from different sides of the argument, not just the dogmatists who are tending to dominate.

Here is a link to a recent discussion of the USS situation by a pensions expert that you may find elucidating:

https://henrytapper.com/2017/07/31/is-the-university-superranuation-scheme-suffering-fantasy-deficits/

Here is another:

https://henrytapper.com/2017/08/09/ex-abundanti-cautela-con-keatings-words-of-comfort-to-uss-members/

Finally, the increase in the USS 'monitoring deficit' is nothing to do with increasing longevity. Demographic changes like that occur over very long periods (eg. at least a decade) not over the short period we are observing. The press reports relate to the Annual Report and Accounts for the year to last March. The last valuation related to 2014, and the monitoring deficit does not reflect demographic changes. The cause of the increased monitoring deficit is the very low interest rates that are being used to update the value placed on liabilities from month to month. Journalists should report that and not simply assume the changes in deficits to be due to rapid changes in longevity.

The USS deficit is really like a house that is in negative equity. It is a valuation that does not involve real money - that is, money that has to be paid in normal circumstances. You can continue living in your house as long as you keep up your mortgage payments. John Ralfe is saying - essentially - that the negative equity has always to be paid off immediately it appears. But any sensible person will take a long term and more balanced view.


Is the USS really in deficit?

Everybody should keep calm about the universities superannuation scheme. Contrary to sensational press reports last week in the THE, Financial Times and BBC, the USS is not actually in deficit - not in the usual meaning of the word ‘deficit’ anyway.


If it were truly in deficit it would not have enough money coming in to pay its outgoings. It would be forced to sell some of its investment portfolio to keep going. But in reality it has investment income each year in excess of £1 billion which is not needed to pay for pensions today and that is available for new investments. It has just bought a large stake in Thames Water, for example. The scheme is cash rich and can remain so for many years. Membership is increasing with over 29,000 new members joining last year.


What, then is the problem? The headline figures quoted are theoretical numbers based on particular hypothetical assumptions about the future, whose realism is in doubt. Many members, the UCU, some universities and some actuaries are questioning whether they really give a true picture of the health of the scheme.

The ‘deficit’ emerges as the difference between the scheme’s assets (its investment portfolio) and liabilities (the value of future pensions benefits). The press reports are sensational because they quote raw figures baldly without any context. The liabilities are estimated to be £72.6 billion, which, with assets of £60 billion, means a shortfall – the ‘deficit’ – of £12.6 billion.

Reporting figures like that as raw numbers, expressed as billions of pounds, without putting them in context is misleading. (It is reminiscent of the way that government debt and deficit are reported in absolute numbers in order to frighten us into accepting cuts in public spending.) Given the size of the USS, with almost 400,000 members, it is actually not surprising that the figures are so large. They need to be put in proper context before any conclusions can be drawn. They represent a funding ratio of 83 percent: the assets are currently worth 83 percent of the liabilities. So is that high or low?

Compared with the funding levels of the almost 6,000 private UK schemes, of which the USS is the largest, it is not out of line. Its funding ratio is fairly typical. The average for schemes in deficit is 83 percent, according to the Pensions Regulator Scheme Funding Statistics 2007. The BT pension scheme funding ratio is 64 percent.

So it is not fair to say, as the FT article claimed, that the USS has the largest gap between assets and liabilities of any scheme in the UK. It is only large because the scheme is very large.

While the USS ‘deficit’ is not out of line with other privately funded schemes, we still need to ask where it comes from in the first place and what it means. The main reason for pension scheme deficits – not just USS – is that the accountants tend to insist on an assumption that schemes be invested only in bonds (even though that may not be true). In this they seem to be following a herd mentality and advocating something which is irrational. Why anyone would believe that investing in gilts at the present record low real interest rates, which entails expecting to make a loss, reduces risk is hard to understand.

But gilt interest rates have really very little to do with the USS pension scheme. After all, the pensions that members will receive are not paid out of the meagre returns from gilts but the much better returns from the long-term investments the scheme actually has, that it has built up over the years, mostly equities and other high-return assets. Such assets – if held for the long term - yield a high return with minimal risk.

[The USS uses this best estimate rate of return to value liabilities but with a substantial – some say excessive – margin of prudence to allow for market volatility of equities and other assets (the technical provisions). However they update this figure regularly using gilt rates, and it is this that appears in the accounts.]

The report also gives an alternative figure for the deficit if liabilities are valued using the actual rate of return from its assets but without the large dollop of prudence. This ‘best estimate‘ for the liabilities figure (as at 31 March 2014) was £38.1 billion, which means the scheme would have been in SURPLUS by £3.5 billion! Of course the necessary degree of prudence needs to be applied here, but it does show that this is not a scheme that is in trouble. We are due another triennial valuation in the next months (with a reference date of 31 March 2017) and it seems likely that the best estimate valuation could well have improved.

Members should stay calm and insist that the scheme remain open to new members and accrual. The biggest threat to the scheme is closing it.


May 26, 2017

The market–based regulation of pensions is a source of risk and deficits

My evidence to the DWP Green Paper consultation on Defined Benefit pensions

May 14, 2017

The ongoing crisis in occupational pensions, that is a result of the closure of many
company superannuation schemes, and their replacement with inferior alternatives, is a
ticking time bomb for society. Millions of workers will, in years to come, face a choice
between retirement with inadequate income and continuing to work into old age.


However it is not clear that there is anything fundamentally wrong with defined benefit pension schemes. A common complaint that one sometimes hears from experienced trustees and finance managers is that a pension scheme that appeared ostensibly to have been in good shape was closed on actuarial advice, after having been shown to be in technical deficit.

I wish to argue in this paper that a major contributor to such deficits are biases inherent in the approach and methods used by actuaries and accountants, based on recent developments in finance theory that are not empirically well founded. The regulatory rules themselves - that are supposed to protect agaist bad outcomes - are actually leading to those very outcomes.

To read more, download the paper here


May 12, 2017

What’s gone wrong with economics?

Lecture to Bath Royal Literary and Scientific Institution

10 May 2017

There is a lot of discussion going on about the state of economics today. A lot of criticism is coming from outside the academic establishment – from students, journalists, public intellectuals and policy makers. This has occurred since the financial crash of 2008 and subsequent recession, although it can also be seen as really an intensification of much older debates about economic thought that have been going on for many years before that. There has been intense debate, within the economics ‘profession’, about the way the subject was done, going back at least to the sixties if not earlier. However it had ceased to take place within the mainstream and nowadays most critical writing is confined to a few fringe academic journals, while the main journals have become almost exclusively the domain of a narrow range of orthodox thinking. This lack of open debate was very unhealthy.

(By the way, economics must be one of a very few academic disciplines whose members refer to themselves as a “profession”. I wonder if this terminology endows the orthodoxy that occupies the pages of the mainstream journals and textbooks with additional authority.)

One of the most remarkable instances of criticism emanating from government circles occurred in 2008 when the queen was visiting LSE just after the crash and she asked the assembled dignitaries why nobody had seen it coming.

One answer is to say that economics is concerned with understanding how the economy works rather than forecasting. After all, nobody would expect a political scientist to forecast the result of every election. But that begs another question: “if economists understand how the economy works, how come they have not been able to design institutions and policies to prevent such crises from happening?”

But anyway many economists are engaged in forecasting and their inability to spot the crash was a major failure of their methodology. The fact that the crash happened was also a consequence of seriously flawed thinking underpinning the policy regime in force.

Following the crash students intensified their complaints about the syllabuses of courses they were being taught. They complained that their courses were too preoccupied with the properties of abstract models not rooted in the real world and they demanded more relevance. For example a group that started at Manchester University called the Post-Crash Economics society
(http://www.post-crasheconomics.com) was set up to campaign for more relevance and methodological pluralism in courses, but it met with limited success. This is actually a renewal of earlier campaigns such as the post- autistic economics movement that began in France in 2000, arguing against the dominance of a single method – which is known as neoclassical economics - and for a pluralism of approaches. They likened the mainstream discipline of economics to someone suffering from autism: someone who continues with the same asocial behaviour regardless of any outside influences. This gave rise to the Post Autistic Economic Review, now renamed the Real World Economic Review. Review. (http://www.paecon.net/PAEReview/ )

So what is the problem? Are the students and critics right? Or is it just that they lack the skills necessary to do mainstream economics?

Is economics too mathematical?

A very common criticism of economics teaching and scholarship generally is that it has become far too mathematical. Students today have to take and pass prerequisite courses in quantitative methods before they can study economic principles. Both mathematical and statistical techniques are required. Also scholarship is heavily mathematical with economics writing in academic journals and textbooks couched in algebraic symbolism which makes it extremely difficult to read for all but a few initiates who already have expertise in the area. The usual response is to say that complainers should just get on with it: that is the way economics is.

It is true that academic writing about economics should be written in clear language and not pretend to be something – mathematics - that it is not. This is a major and valid criticism of the way economics is done.

It is interesting and perhaps somewhat ironic that today’s economists who write in this way are failing to follow the advice of one of the founding fathers of neoclassical economics, Alfred Marshall,
(https://en.wikipedia.org/wiki/Alfred_Marshall )
who was responsible for the supply and demand framework and partial equilibrium analysis of markets. He wrote:

“[I had] a growing feeling in the later years of my work at the subject thata good mathematical theorem dealing with economic hypotheses was very unlikely to be good economics: and I went more and more on the rules - (1) Use mathematics as a shorthand language, rather than an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics.”

His work was mathematically very rigorous but written so as to be comprehensible to the reader. That does not suggest that mathematics has to be a prerequisite to studying economics at undergraduate lev el though it might be needed before conducting research.

There is an issue about what sort of quantitative techniques students should be expected to know. Statistics is essential because economics is all about measurement. But in their first year students only need to be taught basic economic statistics – that is the measurement of the economy. Students should know about how an index number is constructed so they can understand things like the consumer price index, or the rate of growth of GDP, and graphical representation of trends. Only high school maths is required for this. This is quantitative methods for describing the economy at a very basic level, the foundations for a proper understanding.

More advanced topics such as optimization theory, statistical inference and parameter estimation have to do with economic modelling and not required for an economics degree. Some of the techniques students are taught are really of questionable use. It really does not aid understanding or develop useful skills to have to derive demand functions from first principles expressed exclusively in algebraic terms, with a given utility function – very few are likely to ever need to do that in their later career, only those who go on to very advanced theoretical research. Studying the idea of a demand function and the nature and meaning of a utility function are far more important.

So I do not agree with the simple proposition that the subject is just too mathematical. Quantification is intrinsic to economics. But I think that often what is taught is the wrong sort of quantitative methods – more to do with abstract economic modelling than with the measurement of the real world economy. And too much economics scholarship is expressed using needless mathematical notation, a form of jargon. Economists should heed the advice of Marshall and write in clear English.

The reduction of macro to micro: the neglect of Keynesian economics and the ascendency of neoclassical economics

What has gone wrong with economics is not only that there is too much writing couched in needlessly mathematical terms but something more fundamental than that. It is that there has occurred a major shift of focus away from macro to micro. There has also been a shift away from real-world empirical relevance to mainly theoretical argument. Macroeconomics – by which I mean primarily the economics of Keynes – is no longer taught in many universities. By that I mean it is not taught properly. The economics of Keynes has been sidelined.

To continue reading, download the full paper here.


September 05, 2016

Financial Times article arguing that pension scheme response to deficits makes the problem worse

An article in today's Financial Times argues that the conventional approach to pension scheme deficits by "de-risking" and "liability-driven investing" makes the problem worse.

cure_for_uk_pension_funds_deficits_inflicts_more_pain_ftcom.pdf

It makes the same arguments I made in my last blog. See:

http://blogs.warwick.ac.uk/dennisleech/

What the article is saying is directly relevant to the universities scheme, the USS, because it is committing the same mistakes it describes, in common with very many of the 6000 other private sector (because - surprisingly - the universities' scheme is a private sector scheme) schemes.


August 18, 2016

Pension deficits: mark–to–market valuation is the elephant in the room

The chief economist of the Bank of England, Andy Haldane, has said he hasn’t a clue about pensions. It is not surprising when so many occupational schemes have a deficit that stubbornly just keeps on growing. They have agreed a recovery plan with the pensions regulator to ensure there will be enough money to pay the pensions promised when they fall due - but still the deficit grows seemingly uncontrollably.

The latest estimate for the total deficit for defined benefit schemes eligible for entry to the pension protection fund was £383.6bn at the end of June 2016, up from £294.6bn at the end of May an increase of £89bn in one month. The combined funding level has fallen to 78 per cent, close to its lowest ever level. There were 4,995 schemes in deficit and only 950 schemes in surplus.[1]

The blame for this is most often put on the fact that pensioners are living longer than expected. But that is not convincing and can be only part of the answer: deficits are changing too fast to be due to something as slow moving as longevity trends - that are anyway allowed for in the recovery plans that have been devised. The other explanation often trotted out is the catch-all ‘market conditions’ which covers a multitude of factors. This usually means low interest rates, casually and wrongly equated with poor investment returns.

No. It is the regulations governing pension scheme valuations that are mostly to blame for this unsustainable situation. They are the elephant in the room of the pension deficits story that is being ignored by most of the industry. They are not fit for purpose and urgently need to be revised. They force pension schemes to have to deal with extraneous – even spurious - risk factors which exaggerate deficits. The effect – as we have seen in recent years - is to force many schemes to close.

Deficits have grown substantially since the 1990s when minimum funding requirements were introduced. The 2004 Pensions Act set up the pension protection fund to reduce the risk of pensions failing due to the sponsoring company failing. But it also tightened up on funding rules and imposed an inappropriate market-based valuation methodology[2]. Accounting regulations based on this methodology are at variance with real-world economics. They are based on a purist belief in markets as a source of information - ignoring all evidence from academic economics, both empirical and theoretical, showing the limitations of markets as providers of information. They were intended to prevent pension schemes needing to enter the pension protection fund but in fact have had the reverse effect by making sponsor failure more likely.

It is only policy makers who can deal with this problem. They need to take an overview of the consequences of mark-to-market accounting and revise the valuation regulations in the light of experience.


... To continue reading access the full paper here or here.


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The paper has been submitted as evidence to the enquiry being conducted by the House of Commons DWP Select Committee (chair Frank Field MP) and to the DB Task Force by the Pensions and Lifetime Savings Association (chair Ashok Gupta).


June 04, 2016

Will the UK become more powerful if we leave the EU? Voting power analysis suggests not.

A burning question begged by the referendum debate is whether the UK can be more politically powerful if it leaves the EU and regains the full status of an independent sovereign state in all matters than if it remains as a large member of a large and powerful political bloc.

It is a truism that a political actor may have more influence by being a member of a powerful group than it has outside it. It gives up power over decisions taken within the group in order to gain the indirect power from belonging to a powerful group: in other words it benefits from the power of combined forces.

This is essentially an empirical question about weighted voting. In order to answer it in the context of the referendum debate we need to be able to compare a measure of the voting power of the UK both inside and outside the EU. We cannot do that exactly because although the EU has defined voting procedures with precise rules for internal decisions there is not a world equivalent voting body for which we can do a formal analysis for external decisions. Continued


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