April 30, 2018

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.


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


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

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

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)

April 07, 2018

Very misleading THE article comparing DB with DC pensions

An article about the USS pensions dispute in the Times Higher Education by David Voas (Let's defend pensions not defined benefits) gives a somewhat inaccurate account of the issue. It also makes a comparison between Defined Benefit and Defined Contribution pensions that is very misleading.

At the centre of the issue between the union and the employers is what kind of scheme it is. The employers want to end the guaranteed pension that is based on years of service and earnings, and replace it with a defined contribution arrangement where instead of a pension on retirement one gets a pot of money that depends only on what has been paid in and investment returns.

The article argues compares a young person aged 30 near the start of their career with someone nearing retirement, and concludes that the youngster would do a lot better under Defined Contribution. This is very misleading. For most people (almost all in fact) they would get a lot better penson in retirement from a Defined Benefit scheme.

The article actually makes a number of statements that are wide of the mark. And it is not sufficiently analytical.

For example it says, "defined benefit schemes are defunct unless underwritten by the taxpayer." That is not really true. There are schemes in the private sector that are not defunct. And there is no reason why the USS should be defunct without taxpayer support. The problem is with the way the regulations are being applied and the weakness of the employers. While it is true that most of the DB pensions schemes are in the public sector, such as the Teachers Pension Scheme that is normal in the post-92 universities, what Voas is getting at, I think, is a repetition of City group think that applies simplistic generalities.

His description of the problem, though, goes from vagueness to missing the whole point. He writes,"The problem is twofold. Employers struggle to afford the cost of guaranteeing that the benefits promised in 50 years' time will be paid ... Employees are also hit, though, because everyone ends up paying above the odds." (emphasis added) What does this mean? It sounds very bad. It is not factually true. There is no conclusive evidence that employers struggle to pay the pensions in 50 years. All that is required is that the scheme stays open until then and invests in high return assets such as company shares (equities).

The next paragraph is an explaination but is in fact a gross oversimplification to the point of being misleading, revealing that Voas has not understood the arguments: "The basic equation is simple enough: contributions plus investment income equals benefits. Contributions - and even benefits - are fairly predictable, albeit affected by changes in life expectancy. The challenge is to estimate real returns on investment over several decades."

That is not where the problem lies. There would actually be no problem if it were as Voas says. The USS investment portfolio has a high return, an average of 12 percent per year over the past five years, for example, and is expected to continue to do well into the future, since it is skewed towards equities.

The problem is that the liabilities (present value of future benefits) are being valued counterfactually. That is, NOT using the real returns on investments as described. If things were as Voas says, there would not likely be a problem. The problem is that the scheme is being told to assume very poor returns - index linked gilts have a negative return. So the problem is a result of the excessive prudence being forced on the scheme by the regulations and the weakness of the support from the employers.

In order to compare DB with DC, he contrasts two academics with the same salary, a woman aged 30 with an older man nearing retirement. They both receive a defined benefit of 1/75 of salary for a year's work. He claims that for the older man it is a windfall: "he receives substantilly more than his current contribution would support. For the 30 year old it is very poor value. She could conservatively expect her contributions to grow by 2 per cent per annum, thereby doubling her money by age 65. This fund would be worth more than the defined benefits." This is very difficult to make sense of. Why compare these two individuals in this way, by just taking a snapshot of one year. What pension would the young woman get when she retires? How would that compare with the man? Surely what is needed is to compare the pensions obtainable from DB and DC over a whole career, not just one year taken at different stages in life. It is also very superficial. We are not told if the returns are after inflation. All defined benefits are uprated for inflation by the CPI.

And so it goes on. It reads as if the article were simply intended to make the case for DC over DB. But that goes against all the evidence from academic studies and practical knowledge from actuaries. It also goes against the studies that have been done for the UCU by its actuarial advisers, which show that for the great majority of members, it is very considerably more expensive to provide a pension of a given annual amount by DC. Estimates have put this at between 40 percent and 100 percent more.

This piece is extremely poor scholarship.

Observations from a City expert on the USS proposals: Why Change?

These comments on the USS proposals have been written by John Murray, who is neither an academic nor a member of USS, but has an expert understanding of the issues, having over fifty years of experience in the insurance industry.

A sustained large-scale academic assault on decades of mistaken focus on point-in-time market values and inappropriate discount rates may yield results that strike action cannot.’
(Extract from a letter published in the Financial Times on the 13th March 2018 on the subject of the USS dispute.)

His comments below relate to two recent documents provided by USS Managers, entitled ‘2017 Actuarial Valuation’ dated 1st September 2017 and ‘31 March 2017 Actuarial Valuation’ dated 8th December 2017


On the deficit

While the derivation of the discount rate applied is far from clear it does appear as though the apparent shortfall results from the managers’ deliberate intention to shift the fund’s investment portfolio to low-yielding government securities. Without this change there would be no deficit.

On ‘De-Risking’ and Collateral Damage

‘De-risking’ appears to consist of changing the investment profile as described above and then back-filling the resultant shortfall by use of the employers’ current deficit contributions of 2.1% of pensionable salaries. The consequent closure of what remains of the ongoing DB scheme seems to be regarded as collateral damage.

On Risk Generally

  • Referring to long term investment in equities as ‘betting’ or ‘gambling’ is inflammatory, ill-advised and has no place in a discussion of this nature
  • Investing in government securities is by no means risk free
  • Nowhere is the risk inherent in the opportunity cost of missing out on potential equity returns addressed
  • The risk that members may be deprived unnecessarily of a valuable benefit by reason of the adoption of a low-yield investment policy is never even mentioned
  • The only risk that the managers seem to be interested in avoiding is the risk of a problem with the Regulator.

On ‘Self-Sufficiency’

‘It would be difficult to convince the man on the Clapham Omnibus that one achieves self-sufficiency by reducing the income available to the fund’

On Achieving the Stated Objectives

On no common understanding of the terms will the managers’ proposed action achieve the stated objectives of de-risking and securing self-sufficiency.

On the Way Forward

  • The direction being proposed by the managers needs to be abandoned
  • USS is uniquely placed to seek a derogation from the much-criticised pension rules
  • A joint case to make an exception should be put forward by UUK, USS and UCU

Observations on USS Proposals as set out in two documents entitled ‘2017 Actuarial Valuation’ dated 1st September 2017 and ‘31 March 2017 Actuarial Valuation’ dated 8th December 2017

In the notes that follow, the above documents are identified as 9/17 and 12/17 respectively. The latter document is to some extent an update of the former but is much less extensive.

1. Summary and Overview
1.1. Although neither of these papers is presented as a set of proposals for action, but rather as a review of certain suggested valuation assumptions, they very clearly contain implicit proposals that involve a radical restructuring of the USS (the Scheme)’s investment portfolio.
1.2. Boiled down to their essentials, the proposals are aimed (perhaps not directly but certainly effectively) at reducing the investment income that the Scheme will receive in the future, thereby creating a funding deficit. One of the consequences of this action will be the need to remove what remains of the final salary scheme going forward.
1.3. The reasons for this action are given as either ‘de-risking’ or creating ‘self sufficiency’. These notes will argue that the proposed action will achieve neither of these objectives while unnecessarily depriving members of what is left of a valuable benefit.
1.4. These notes also include suggested possible ways out of the current predicament.

2. Introduction
2.1. The Scheme’s financial position is set out below:

USS Funding Position – Gap Analysis
Source: 31 March 2017 Actuarial Valuation dated 8 December 2017

Best Estimate Approved Basis Gap

Accrued Liability 54.8 67.5 12.7
Assets 60.0 60.0
Surplus/Deficit 5.2 -7.5 -12.7

Self-sufficiency 82.4 82.4 0

Mean discount rate
(above gilt yield) 2.31% 1.20% -1.11 (-48%)

2.2 The expression ‘Best Estimate’ in the first column should not be confused with the business term ‘Best Case’. In the Definitions at p 57 of 9/12 ‘Best Estimate’ is defined as ‘The trustees’ unbiased view of the future outcome for different variables without adjustment [or] with margins of any kind. It is consistent with the median (or 50thpercentile) outcome’. This might fairly be translated as business ‘Mid Case’. Moreover, the definition of ‘Discount Rate’ in the same glossary says ‘The discount rate for technical provisions is determined by the expected investment return less a margin for prudence’, so it may be expected that this mid case outcome does in fact contain some element of caution.

2.3 The term ‘Approved Basis’ might be better described as ‘Managers’ Selected Basis’. The deficit that appears in this column is the result of the lower discount rate employed. But this column should not be confused with ‘Worst Case’. It is not an attempt to see what will happen if the margin above the gilt yield happens to drop by 48%. What it represents is the expected deficit that will result from changing the approach in line with the comments made in the body of the documents. In other words the deficit does not come about as the result of some possible economic downturn but as the direct result of action that the trustees are, by implication, choosing to take. The actual discount rate is not made explicit but is expressed as a margin over the gilt yield. There are several sets of numbers given in the documents but again the mean rate is never made clear. The nearest clue is at p 10 (12/17) where, under the general heading of ‘Investment Return (discount rate)’ it says that ‘This approach therefore includes a provision for a gradual investment de-risking [i.e. moving to gilts or equivalent] to take place over years 1 to 20’. As far as it is possible to tell, this seems to explain the movement in the mean discount rate between the ‘Best Estimate’ and ‘Approved Basis’. The deficit would not, therefore, be expected to arise if things were to remain as they are.

2.4 The expected rates of return on different types of investment presently in use are set out below. The effect of the proposals, basically to shift from equities to gilts, can be clearly seen.

Projected Real Rates of Return (i.e. adjusted for inflation)
Source: 31 March 2017 Actuarial Valuation dated 8 December 2017

Asset Class 30yr Expected

Equities 3.64%
Property 3.23%
Listed Credit 1.45%
Index Linked [Gilts] -0.76%
Cash -0.56%

3. Why the Change?

3.1. The reasons given are described as ‘de-risking’ or seeking to achieve ‘self sufficiency’. The two concepts, as used in the reference documents, are closely interrelated. Self-sufficiency is described at p 58 (9/17) as ‘The value of assets that are required to meet the Scheme’s accrued defined benefit liabilities while adopting a low risk strategy. By a low risk investment strategy we mean one for which there is a low probability of ever requiring additional employer contributions to fund benefits accrued to date.’ Note that this does not include benefits that might be accrued in the future.

3.2. One might well ask why it is thought that self-sufficiency is best achieved by moving to a class of assets that has traditionally produced such a poor return. And also if it is correct to describe gilts as ‘low risk’. These matters are addressed at 4 and 6.

3.3. It is safe to say, however, that this notion (shifting to gilts or similar) runs throughout both documents as though it was a given. Sometimes it is denied, for example at p 43 (9/17) it says ‘The trustees apply a ‘discount rate’ to the liabilities which is based on assumed returns from current and planned future asset allocations. This does not adopt a formulaic approach to setting the discount rate linked to gilt yields’. But at pp 49 & 50 of the same document it says ‘For the ‘self-sufficiency’ and ‘economic’ bases the discount rate assumes a term structure derived from the yield of fixed interest gilts appropriate to the date of each future cash flow (extrapolated for cash flows beyond the longest available gilts) as advised by the Scheme Actuary. For the ‘self-sufficiency’ basis a margin of 0.75% is added’. So practice would seem to differ from theory.

3.4. The real reason for the proposed change is never articulated but it is not too difficult to divine. The objective of the Scheme managers is to switch the investments to what at p 28 (9/17) are referred to as ‘bond like’ investments aimed at producing the gilt yield plus 0.75%, and then to fund the resulting deficit by use of the (employers’) ‘current deficit contribution of 2.1% of pensionable salaries’. This deficit, it is estimated, will be eliminated in eight years (pp 24&25 9/17). After that they hope that the income from the ‘bond like’ investments will be sufficient to ensure that the employers will not need to shoulder any further increase in their contribution.

3.5. It is, of course, inevitable that defined benefits arrangements are discontinued at this stage otherwise, with such a poorly performing investment portfolio, the contributions required to keep these benefits going would be enormous.

3.6. There is a driver behind the driver and that is current pensions legislation which pushes schemes down the gilts route. The essentially flawed thinking behind this legislation is considered at 4 and 7. It is in this area that the real battle lies (see 7.2) and it would be valuable if the trustees could be brought on board. The managers’ intention is to reach some notional ‘safe haven’ whereby if things do go wrong they have assured the trustees that they will be free from any liability because they have followed the ‘safe’ route. This should secure a quiet life for all (except the Scheme members).

4. Investment, Gambling and Risk

4.1. Before moving on to consider a way out of this morass, it would be opportune to take some arguments off the table before they are employed as a counter. It is sometimes contended, for example, that investing in equities constitutes gambling and that using this form of investment is equivalent to ‘betting’ the scheme’s funds on the vagaries of the stock market. As we will see below, there is risk inherent in all types of investment but it is important to differentiate buying equities to hold for the long term and buying and selling in short order with a view to a quick profit: the former is investing and the latter may be considered a form of gambling (like the activities of a day trader). Moreover it is worth bearing in mind that equities, as a class of investment, have outperformed all other forms of investment, including UK house prices, over the long term (and what is a pension fund if not a long-term investment?) or at least in the period from 1900 to end 2017. See Global Investment Returns Yearbook: Credit Suisse (publ.). Talk of gambling or betting is inflammatory, ill-informed and inappropriate in this type of discussion.

4.2. Government bonds, on the other hand, are by no means risk-free investments as is sometimes claimed. Some of the risks involved are implicitly acknowledged in the reference documents but it would be as well to make them all explicit here.

4.2.1.Matching Term Risk
This is acknowledged by implication on p 10 (9/17) where it refers to ‘...cash flow (extrapolated beyond the longest available gilts)...’ Pension funds are very long–term undertakings whereas government bonds have end dates and it is often impossible to match the pension terms with government securities. This risk does not exist with equities.

4.2.2 Assumed Future Interest Rates Risk
There is an assumption by the managers that [bond like] rates will revert to ‘normal’ in ten year’s time (see the jump in the discount rate at year 11 in the table on p 51(9/17) and also p 5 (12/17). At p 8 of document 9/17 it is observed that ‘If interest rates do not in fact revert as forecast to the levels proposed (sic) by the trustees, then future contribution requirements could increase…...’ Well, yes and maybe a stronger word than ‘could’ would be appropriate. This risk is a heavy one and could be avoided. They got it wrong in 2014 when they thought that rates would have reverted by 2017. See p 9 (9/17) ‘Between valuations, long-dated index-linked gilt yields have fallen from already historically low levels by a further 1.5%, making them more expensive than in 2014. As a result the trustees could not de-risk the portfolio under the funding triggers agreed at the 2014 valuation’.

4.1.3 Reinvestment Risk
Because government securities are issued for a fixed period, they are automatically redeemed when the period ends. It is by no means certain that a similar rate of return will be available on issues then coming onto the market. See the remarks about extrapolation of cash flows under Matching Term Risk

4.1.4 Pro-Cyclicality/Availability Risk
If everyone is seeking to invest in bonds then this will drive the prices up and the returns down. This is implicitly acknowledged at p 9 (9/17) also see under ‘Assumed Future Interest Rate Risk’ (above). No mention is made of the fact that, if the government is looking to reduce the level of its borrowing, there is the risk that there may not always be sufficient bonds issued to meet demand. This is already a factor in Germany.

4.1.5 Sovereign Default/Concentration Risk
While the British Government has never so far defaulted on a bond, sovereign default is not unheard of and the future is difficult to predict. Going almost exclusively for government bonds introduces a risk concentration element which does not exist with a well diversified portfolio of equities

5 The Risk that Durst Not Speak its Name

There is a very significant risk that is not even alluded to in either of the reference documents, namely that the members may be deprived of what remains of a most valuable benefit for no good reason. Future history could well show that by maintaining a portfolio of mainly diversified equities sufficient income would have been produced to keep current benefits in place. This is the clear implication of the ‘Best Estimate’ valuation. Trustees owe a duty to every participant and not just the Regulator (as one could be forgiven for imagining reading the reference documents).

6 De- risking and Self-Sufficiency

6.1 So far as concerns the question of removing risk it is difficult to see how the proposals will achieve this, unless one regards equity investments as inherently so very risky that they must be avoided at all costs. But as has been demonstrated above, there are many risks associated with government bonds and it could be argued that the real risk that the planned action will run is the opportunity cost of not investing in equities and so missing out on the returns that have traditionally been available from this source. The only risk that the managers seem to be intent on avoiding is the risk of possible problems with the Regulator.

6.2 It would be difficult to convince the man on the Clapham omnibus that one achieves self-sufficiency by reducing the income available to the fund. It is only the very strange definition of self sufficiency contained in the document (first create a deficit and then seek to back-fill it) that will be secured by the proposed approach.

6.3 There is a powerful argument to say that what is being proposed will achieve neither the reduction of risk nor any degree of self-sufficiency.

7 A Way Forward

7.1 As has been demonstrated above, the proposed approach fails in its objectives and, by way of collateral damage, ends defined benefits going forward. It would be wise, therefore, to abandon ‘de-risking’ and revert to a more balanced portfolio of investments, including a substantial equity element. This will not be so easy to achieve, however. As explained at 3.4 to 3.6 (above) there are regulatory issues to consider. It is most probable that the managers will have intimidated the trustees and convinced them of the absolute necessity of reaching ‘safe haven’ if they are to be sure of avoiding any risk of personal liability. It would not be the first time that such a thing has occurred and the natural caution of the trustees is understandable in the circumstances. Further, the Regulator may be expected to support the managers’ position. The Regulator’s role is to enforce the rules, not to consider the best interests of the scheme members.

7.2 The easiest way to arrest the planned journey to Armageddon would be to seek a
derogation for the Scheme. There are grounds for this. At pp 35 et seq. (9/17) reference is made to the strength of the employers’ covenant. The heading at 1 on p 35 states that ‘The covenant is uniquely robust’ and at 2 that it is ‘........rated as ‘strong [the highest rating] by PwC’. For all the reasons explained in the document this looks to be a fair assessment. One could therefore argue that the Scheme, in its unique circumstances, should be allowed to derogate from the real or implied rules of pensions legislation and to continue with a (truly) balanced portfolio approach. It follows that the trustees should at the same time be granted immunity for any adverse outturn that might follow the granting of this derogation.

7.3 There is already support for this view. In a letter published in the Financial Times on 13thMarch of this year and referring directly to the USS, the joint signatories called for ‘A sustained large-scale academic assault on decades of regulators’ mistaken focus on point-in-time market values and inappropriate discount rates…’ And it should be emphasised that the requested derogation would cost the taxpayers nothing. To have the maximum chance of success the application should be made jointly by UUK, the Trustees and the UCU to the Pensions Minister.

7.4 Another, though less certain, approach would be to see if the trustees could avail themselves of what is known as ‘the business judgement rule’ which is available to members of company boards. This says effectively that directors cannot be held liable to their shareholders for an adverse business outcome if they made the decision in good faith. This can apply even to contrarian decisions such as assuming a rise in oil prices when, in fact, they fall. Broadly the claimant, to have a chance of success, needs to be able to show that the directors acted in their own interests and against the interests of the shareholders or favoured one group of shareholders over another. It is a powerful defence and it might be worth finding out if the trustees could take advantage of it or something similar. If the current advisers still insist on the proposed course of action then it should be possible to find some advisers who will take a different view. After all the shortcomings of the current pension rules and their consequences are well known.

Badly designed regulation causing pension schemes to fail

Government regulations for defined benefit pension schemes, as they stand at present, under the Pensions Act 2004, are a major factor contributing to the pensions crisis that has seen the closure of scheme after scheme.

The problem stems from the rule requiring schemes to be judged on a simple comparison of market-based capitalized values of assets and liabilities every time there is a valuation, every three years. This rule is misguided for two reasons: because it is arbitrary in that it does not provide a meaningful comparison; and because it greatly magnifies risk, costing a lot of money to offset.

The rule is arbitrary because of the inconsistent way it requires assets and liabilities to be compared. The assets must be valued at market prices on the valuation date. But the value of liabilities, which is not priced in a market, must be estimated as some kind of present value of the pension promises. Since pensions consist of a stream of payments to retirees for many years into the future, there is no asset that can be traded in a market, and the regulations do not prescribe precisely how calculation should be done. The liabilities value is therefore essentially a notional sum.

The two sides of the balance sheet are calculated using very different methods. I will discuss the problems with the assets side later but first consider the liabilities figure. This is meant to be an amount of capital today that would, if invested, yield just enough to pay the pension benefits.

This thought experiment is a matter left to the trustees, with general guidance from the regulations and actuarial advice. They must decide whether – hypothetically – to invest in ‘safe’ bonds or ‘risky’ equities and other growth assets, or a mixture, subject only to the need for having regard to prudence. A sensible choice – you might think – would be to use the actual asset portfolio they have invested in. That would be consistent. However they often find themselves under great pressure from professional advice not to do that but to assume a ‘risk-free rate’ such as the return on long term gilts. Accountants would probably say it is mandated by FRS102. (By the way, even if they switched their portfolio into government bonds it would not be risk free.)

Thus, assets and liabilities are constructed using different – inconsistent – methodologies, making the difference between them – the ‘deficit’ or ‘surplus’ pretty arbitrary. A scheme that is open to accrual can be in ‘deficit’ even though it may have positive net cash flow and is not having to sell capital: in other words it is not in deficit in the way we usually understand the word. That a scheme is in ‘deficit’ is often – usually – reported as a bald fact without a proper health warning.

A notable example that is attracting a lot of ill-informed comment is the country’s largest funded scheme, the scheme for the older or pre-92 universities, the USS; the employees’ union, the UCU, is making my point but the USS executive show little sign that they are willing to listen. However the employers’ body, the UUK, have said they are willing to look at it in a joint experts’ panel with the union.

When a scheme is in notional deficit – as most currently are because near-zero gilt rates have blown up the liabilities – the regulator requires employers to make recovery payments. For an open scheme this often presents an existential threat if the employer cannot afford the payments.

Clearly, the valuation of liabilities is a serious problem which means that deficits or surpluses are arbitrary. Since they are the difference between two large and imprecise numbers they are also very volatile.

But things get much worse when we consider what the valuation of the assets means.

The regulations require assets to be valued at market prices. But, if the scheme is open, asset prices are the wrong indicator because pensions are paid out of earnings. In theory this should not matter because asset prices should exactly reflect the underlying earnings in dividends, rents, interest and so on. But markets are not perfect – in fact far from it – and this equivalence does not hold in practice.

This point is widely ignored by financial economists, even though it is well known to economists. Studies by the Yale economist Robert Shiller and others, have compared asset prices with their theoretical values based on discounted future earnings, and found them to be massively too volatile in practice. Equity prices, for example, are known to be many times more volatile than the economic fundamentals, that is, expected dividends, would suggest. The same is true of bonds and real estate.

It cannot be stressed enough that excess volatility is large. For example, in his book “Irrational Exuberance”, Shiller reports that “only 27 percent of annual return volatility of the US stock market might be justified in terms of genuine information about future dividends”. This would imply excess volatility of equity market prices by a factor of around four.

This does not matter much for a closed scheme where the assets must be enough to cover the liabilities whatever discount rate is used. The focus is on aligning finite assets and liabilities. Market valuations are inescapable.

But it matters a lot for an open scheme that holds its investments long term for income. Rather than at market prices, assets should be valued as the capitalized value of projected future expected earnings, using the same discount rate as for liabilities. This is much less volatile than asset prices.

But the regulations insist on using asset prices, with the result that volatility – which otherwise would be inessential to an open scheme – must be treated as a source of risk. The regulations therefore pose a major threat to an otherwise healthy and sustainable scheme because the notional ‘deficit’ will need to include an allowance to cover the risk due to excess volatility. Yet this market volatility is irrelevant to the financing of the scheme on an ongoing basis.

The regulations are intended to protect accrued pensions benefits against company sponsor failure. But there is two-way causation and schemes may close because the cost to the employer of plugging ‘deficits’ is too high. This has been a major factor in schemes closing. If deficits are over-stated because the rules treat market volatility as risk, then the rules themselves are unfit for purpose.

This therefore suggests two recommendations for reform. First, value an open scheme on an ongoing basis, rather than using market asset prices, which is an implicit assumption it is about to close. Rather than comparing market-priced assets against capitalized liabilities, trustees would get a better picture by comparing the profile of projected income and outgo. That would avoid both the arbitrary choice of a discount rate and the increased risk due to excess volatility of market prices. This reform would remove the reverse causality of an artificial deficit undermining the covenant. There still remains risk of the loss of employer support.

The second reform would deal with that risk. The Pension Protection Fund should protect open schemes as well as closed ones. A pension scheme does not have to close on employer bankruptcy if the work of the employee members continues with or without another employer sponsor. In extremis the PPF could act as sponsor. As a statutory body the PPF can afford to be a patient investor, investing for the long term to gain the equity premium. This means that the a scheme transferred to the PPF would have a lower deficit or surplus when valued as above.

The PPF will be able to support open schemes as well as closed ones. This would reduce the pressure on open schemes to close. The PPF should become a real safety net enabling companies to take a long view of their open schemes, thereby saving them having to make provision for short run market volatility as risk, reducing the cost of pensions. A consequence of this will be greater confidence in DB schemes many fewer scheme closures.

April 05, 2018

Call for rethink on regulations based on the USS dispute

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

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

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

curtiss and wilkinson

March 24, 2018

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

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

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

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

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

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

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

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

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

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

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

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

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

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

March 21, 2018

Response to Urgent update from the USS trustees from member

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

Dear USS,

Thank you for your “Urgent update from the USS trustees”, which I received on 17 March 2018, and which helped to dispel some of the rumour and disinformation that has circulated around the pensions issue. It is a great relief to learn that I am not expected to live to 147 years of age.

A number of other even more scurrilous and damaging pieces of misinformation have come to my attention, and I hope you can clear up these pieces of mischief before they inflict further damage on the reputation of USS and the higher education sector.

I have heard a vicious rumour circulated by the BBC’s education and family correspondent that the chief executive of USS, Bill Galvin, received an £82,000 pay rise this year, bringing his pay package up to £566,000 per year.[1] Only the most hardened cynic could believe this. It would, after all, mean that his pay rise alone is greater than the annual salary of many of those whose pensions the USS has proposed drastically to reduce.

What gives this rumour a particularly nasty edge is that after claiming that the running costs for the pension scheme are £125 million per year, including two staff members earning more than £1 million, the BBC correspondent quotes Mr Galvin as saying that the pension scheme is “excellent value”.

I think it would be a good idea to ask the BBC to publish a retraction, because this sort of rumour is likely to undermine the reputation not only of USS but of the higher education sector as a whole. I hope I will receive another urgent update on this matter as soon as possible.

An even more damaging piece of misinformation surrounds the results of the September 2017 survey of member institutions of USS. USS reported the survey found that 42% of employers wanted a lower level of risk.[2] This finding justified the “de-risking” exercise that increased the projected deficit in the pension fund and which ultimately gave rise to this unfortunate dispute. Could there be any greater mischief than the ugly rumour, originating with the Financial Times’s pension correspondent, that UUK “told the FT that Oxbridge colleges accounted for one third of the total wanting less risk” because Oxbridge colleges “are employers in their own right” and hence each college was counted as having an independent vote?[3] If a third of those wanting lower risk were Oxbridge colleges, this would mean that, beyond Oxford and Cambridge, the opinions of barely a quarter of the respondents to the survey justified the reduction in benefits that led to the strike.

Anyone gullible enough to believe that USS would accept this sort of gerrymandering must think that we still live in feudal times! I think it is important that USS nip this story in the bud. It is the sort of thing that might otherwise lead to the complete collapse of trust in both USS and UUK.

The thing that worries me, though: how did hackers manage to plant these stories with the BBC and the Financial Times correspondents? Could this be part of a concerted digital attack by a hostile foreign power?
As if that weren’t enough, the rumour-mongers must have hacked into Cambridge University’s response to the September 2017 survey, in which one finds the following justification for lowering the level of risk: “The University (and the other financially stronger institutions) continues to lend its balance sheet to the sector, which contains the cost of pension provision for all employers. In a competitive market for research and student places the University would be concerned if this appeared to be having an adverse effect on the University’s competitiveness (by allowing competitor universities access to investment financing or reducing their PPF costs in a way that would not be possible on a stand-alone basis).”[4]

No one could possibly believe that Cambridge University would be so selfish as to drive the whole education sector into turmoil in order to improve its relative position on the capital markets vis-à-vis other universities—or that the USS posture would collude with this sort of behaviour.

I hope you can see the urgency of correcting this bit of misinformation. The mystifying thing, though, is how someone has managed to plant the quoted statement in Cambridge’s response to the September 2017 survey, found on Cambridge’s own website. What evil force is trying to tarnish higher education in this way?
What USS must correct most urgently of all, though, is the following narrative: that in 1996, rather than build up a healthy surplus, USS permitted the employers to reduce their pension contributions from 18.55% to 14%, on the understanding that there would be no reduction in benefits; that the employers reduced their funding between 1997 and 2009, when hard times hit us all; and that when the fund was found to be in deficit, rather than ask the employers to pay a surcharge to compensate for their earlier reduction, USS instead instituted a series of reductions of benefits to the pension beneficiaries.

This story is the most damaging of all. Any child who has been immunised against profligacy by the fable of the grasshopper and the ant would recognise the impropriety in allowing the grasshopper employers to reduce their contributions in the apparently endless summer of 1997 to 2009, then requiring the employees (who, conscientious as we are, never reduced our contributions) to accept lower benefits in response to bad times. No responsible adult would let the employers get away with this, let alone an organisation like USS with fiduciary responsibilities. If we were to believe this story, we would have to believe that every time push came to shove, the independent chair of the Joint Negotiating Committee sided with the employers. That is not possible, because the very first words of the “urgent update” you just sent say that USS “has the primary duty to act in the best interests of the scheme’s beneficiaries”. No organisation would be so shameless as to allow itself to quote those words having permitted the employer to treat the beneficiaries in the way this mean-spirited story recounts.

I do hope that USS sees the urgency of dispelling the rumours that I have reported. If they continue to circulate, they will reinforce the belief that USS has acted as the servant of the most aggressive employers in the sector, who want to improve their balance sheet position even if that poisons relations between universities and their staff for a generation, destroys trust in USS and UUK, drives university employees into penury in their old age, tarnishes the reputation of the higher education sector, and thus does irremediable harm to the nation.

I look forward to your next urgent update containing apologies from all of those whose words and actions have brought USS and higher education into disgrace.

With my best wishes,

a USS beneficiary

[1] Sean Coughlan, BBC News education and family correspondent, “University Pension Boss’s £82,000 Pay Rise,” http://www.bbc.co.uk/news/education-43157711.
[2] “UUK Responds to USS’s Consultation on Funding Proposals”, https://www.uss.co.uk/how-uss-is-run/valuation/2017-valuation-updates/uuk-responds-to-usss-consultation-on-funding-proposals.
[3] https://twitter.com/JosephineCumbo/status/966205373349801985.
[4] Response to Question 3B, “University of Cambridge
Responses to Questions from the UUK Survey on the 2017 USS Valuation,” https://www.staff.admin.cam.ac.uk/general-news/uss-pension-valuation.

Why some actuaries are getting pension schemes wrong

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

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

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

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

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

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

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

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

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

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

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

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

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

March 16, 2018

Reply to Sally Hunt

Writing about web page https://www.ftadviser.com/pensions/2018/03/15/why-pensions-are-worth-striking-over/?page=1

This is my response to what Sally Hunt, the General Secretary of the University and College Union, has written about the latest develpments in the USS dispute on the FTAdviser website.

What is puzzling is why the union has asked for the employers to increase their contributions, and agreed that members should pay more, when the key issue is the valuation methodology which points in the opposite direction. The union committed a strategic error when it did this. It is to be hoped that it can retrieve itself from it.

Fundamentally the dispute centres on the strength of the employer covenant: that is, the member institutions’ ability and willingness to support the scheme. Because the employers can collectively stand behind the scheme indefinitely, due to its “last-man-standing” structure, the covenant is patently strong. The UCU should not compromise on this point in any way.

This means that the USS can remain open to new members and accrual indefinitely and put its spare funds into investments that will make a high return over the long term. Remember that the scheme makes a large surplus every year - almost £1 billion - and this is what it has been doing very successfully for many years. Forecasts of income and outgo, going well into the distant future, that have been made by the UCU actuary, have shown that continuing with this strategy can provide the pension benefits promised to members. On this basis, there is not a large so-called deficit. There is probably a surplus – for example as is indicated by the Best Estimate valuation in the September USS consultation document.

The problem is that the different valuation methodology being insisted on by the employers (and the USS executive) contains a sleight of hand that makes it seem like there is a large deficit. They use circular reasoning that contains a serious inconsistency. The negotiations and industrial action should have been - and should still be - directed at this, in effect, big lie.

We know that the design of the scheme is 'last-man-standing' where all the institutional members support one another against the prospect of individual institutions being unable to support the scheme. The bankruptcy of one university, for example, leaves all its member staff’s pensions entitlements unaffected. This is obviously a very strong covenant because simultaneous bankruptcy is not a plausible eventuality given that all the pre-92 universities are well established institutions of great public benefit and always will continue to be so collectively, even allowing for some reorganization, such as mergers and closures of some institutions.

But if, on the other hand, we consider a scheme for employees of – let us say – a private company that operates in a risky market place, there could only be a very weak covenant. There would be a lot of risk. The scheme’s portfolio investments would need to be in low risk assets such as bonds in order for the scheme to be able to pay the pensions in the not unlikely event that the business eventually closes. This means more cash must be provided to pay the benefits, and the liabilities, must be very much higher than if the covenant is strong.

Therefore it is clear that an assessment of the covenant should be based on an objective appraisal of the likelihood of the scheme closing, independently of the pensions liabilities. Having a high pension liability is not in itself an argument for saying the covenant is weak. That would be circular reasoning because the estimate of the liabilities depends on the strength of the covenant.

Yet that is precisely what the UUK employers and the USS executive (and even the pensions regulator) are doing. They all base their covenant assessment on a hypothetical view of the ability of the sector to support the scheme in financial terms. This puts the cart before the horse because their liabilities estimate assumes there to be a high risk of failure – a weak covenant in the first place. They are using circular reasoning and have slipped in the conclusion they appear to wish to arrive at: that the scheme is too risky to be sustainable.

The UCU negotiators should point this out. And they should not accept these arguments that show the covenant to be weak based on an implicit assumption that it is weak in the first place.

Best Estimate valuation

As an aside, we are told that the Best Estimate valuation can’t be used because it will be correct only 50 percent of the time, therefore as likely to be wrong as right. This is both wrong and irrelevant. Where the employer covenant is strong, the scheme trustees need not worry about short-term volatility of its investment portfolio, and can invest in high-return assets for long term income. The liabilities should be estimated using the Best Estimate of the portfolio return, with a suitable margin for proper prudence, of course.

What is an Independent Review?

Finally, there is the question of the proposed panel of independent experts. It is a very unwise move for the union to agree to this. Not only does it beg a number of questions about the composition of, and procedures to be followed by, this group, it also says that the union has little confidence in the case it is putting forward.

How will the members of this group of experts from academia and the pensions industry be selected? There are very many senior academics who are expert in accounting and finance who do not question the received industry norms of what are often called generally accepted principles. There are even Nobel prizewinning economists among them. Yet it is precisely such principles that we must challenge. The UCU policy is in fact to argue against the application of the conventional valuation of pension schemes used by company accountants.

Many if not most actuaries have been persuaded that they should employ the tools of modern finance theory such as the efficient markets hypothesis. Such is evident from some of the statements by the pension regulator and the USS Executive, also many actuaries. Would we expect an independent expert to agree with or criticize this kind of analysis? The actuarial profession was told a few years ago, in several reports, that they ought to use ‘modern finance theory’. They have taken this advice to heart. Yet this is precisely where the problem lies, and to call for the whole matter to be delegated to an independent panel of experts is to back away from dealing with the issue.

Then there is the question of how the expert body will be constituted. Will it include members who have expressed views in the debate already, or does the word independent preclude them? Will it meet in public? Will its deliberations be open to scrutiny? Will its membership be limited in number? In other words, will this independent group be subject to the normal modalities of academic enquiry and discourse? It is after all the function of academia to find out the truth by open, free debate. That is what universities are for.

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