Sense about the deficit by Simon Wren–Lewis

In his latest blog, Mediamacro myth 4: The immediate necessity of belt tightening ,Simon Wren-Lewis demonstrates the folly of governments trying to cut the deficit in a recession when interest rates are as low as they currently are.

We must always remember that a country is an economy not a company or a single household. Attempting to cut the government deficit in a recession only succeeds in making things worse.

Dennis Leech : 25 Apr 2015 01:27 |  Tags: Keynesian Economics |  Comments (0) |  Close comments |  Report a problem

USS reforms: DC contributions in the hybrid scheme will be too little too late

Mike Otsuka of LSE has used the USS online modeller to make some interesting comparisons to show how much worst value for money the new DC (defined contribution) section will be compared with the DB (defined benefit - CRB or FS).

I've now posted a follow up to my "Using USS's modeller to show how much worse DC is than DB" post. This one is called "DC contributions in the hybrid scheme will be too little too late". Here it is on Facebook:

https://www.facebook.com/mike.otsuka.9/posts/350697368463862:0

The text and a chart are also below my signature.

Best,
Mike

personal.lse.ac.uk/OTSUKAM/

DC contributions in the hybrid scheme will be too little too late:

This chart illustrates a fairly serious design flaw in the proposed hybrid DB/DC scheme. It compares the new CRB defined benefit (DB) pension that a £55,000 salary will generate with the equivalent annuity that one could purchase if one earns £55,000 in the new defined contribution (DC) section.

What the chart shows is that one needs to keep one's DC pension pot invested for a long time, and at a fairly high rate of return, in order to generate enough wealth to purchase an annuity that matches or exceeds the CRB DB pension. Even at the USS consultation modeller's highest rate of return of 7.5%, one needs to keep one's DC pension pot invested for over 30 years in order to purchase a matching annuity.

Academics in USS won't, however, start putting much money into their DC pension pots until they're earning higher salaries later in their careers. Perversely, members will end up making more and more DC contributions when they will yield less and less of a pension per pound contributed. This flaw in the system will be magnified if the default DC fund involves the common practice of 'lifestyle' de-risking of one's pension pot into lower-risk, lower-return assets as one nears retirement.

This problem would be mitigated somewhat if USS members are allowed to keep their DC pension pots invested in USS funds throughout their retirement. Under this scenario, pension income would be generated via a gradual drawing down of their pot in retirement, rather than via an exchange of their entire pot for an annuity at the beginning of their retirement.

A move to collective DC would provide further mitigation. Under CDC, USS could make use of investment and longevity risk pooling, plus a continual and long-term investment of the collective fund in return-seeking assets, in order to try to achieve the target of a pension that is equivalent to the CRB DB pension.

An illustration of how much worse the defined contribution (DC) part of the proposed USS hybrid pension is than the defined benefit (DB) part:

Assume that you are a man who will turn 45 in 2016 and who will retire twenty years later at 65. According to the USS consultation modeller, if you earn exactly at the DB/DC threshold of £55,000 + CPI for those 20 years, that will generate a DB pension of £14,310 per year, plus a lump sum of 3 times that amount, in today's pounds. The cost of this pension to you is an employee contribution of 8% of your gross salary.

If, at the same 1/75 accrual rate, the threshold had been twice as high (£110,000 + CPI), and you had earned at precisely that higher threshold for 20 years, then your pension would have been twice as great: £28,620 per year in today's pounds.

Suppose, now, that you earn twice the DB/DC threshold under the current hybrid DB/DC proposal. How much and how well, according to USS's modeller, would you need to invest your DC pot tied to the £55,000 of your earnings about the threshold in order to match the pension of £14,310 per year (plus a lump sum of 3 times that amount) on the DB portion of your pension below the threshold?

To answer this question, let us first assume no extra employee contributions above the required 8%. Let's also assume the default setting of 5% annual returns on one's DC pension pot. Here the modeller indicates that the annuity (plus lump sum of 3 times that amount) that you could purchase would be worth only £7,060 per year, or less than half of what the DB pension provides for the first £55,000 of your income. Even if you slide the modeller setting all the way up to the highest returns of 7.5% per year, that would generate a pension of only £9,687 per year. At that high rate of return, you would need to contribute an additional 3% of your gross income (or 11% total) to accumulate a pension pot large enough to purchase an annuity equivalent to the DB pension of £14,310 on the first £55,000. If we assume USS's default return of 5% per year, your employee contribution would need to be twice as great as for your DB pension (i.e., 16% rather than 8%) in order to generate an equivalent pension.

A 5% return is twice USS's assumed rate of inflation of 2.5%. There is no investment available that guarantees such a return. Perhaps it would be possible to invest in inflation-linked bonds that are nearly guaranteed to keep pace with inflation. But one would need to spend 21% of one's income (13% in addition to one's 8% employee contribution) to match the £14,310 DB pension if one's rate of return is at the assumed 2.5% rate of inflation.

Dennis Leech : 09 Apr 2015 12:43 |  Comments (0) |  Close comments |  Report a problem

UUK gibberish about USS

Dennis Leech : 02 Apr 2015 01:31 |  Comments (0) |  Close comments |  Report a problem

Meeting between academic pensions experts and USS CEO

Following their letter to the USS trustee, signed by many of the country's leading academic experts on actuarial science, my colleagues Professors Jane Hutton Saul Jacka of the Statistics Department were invited to meet the USS chief executive, Bill Galvin.

Jane has now posted the following account of the meeting on her website.

Meeting with Bill Galvin, CEO of USS.
Saul Jacka and I were invited by Bill Galvin, CEO of USS, to meet him 'in a spirit of openness and transparency'. The meeting took place in London on Friday 27 March 2015. Jeff Rowney, the senior internal (USS) actuary, Ali Tayyebi, the scheme actuary from Mercers and Brendan Mulkern, Chief Policy and External Affairs Officer for USS were also present. Although Bill Galvin initially made his excuses, he stayed for almost an hour.

Ali Tayyebi made it clear that a major driver for the single estimate of the deficit which has been made public was the UUK's insistence that the employers' contribution could not go above 18%, as they could not afford more. However, UUK also insisted that the salary forecast should be CPI + 2%, (RPI + 1%, or they might be minded to accept RPI+0.7%), substantially above the historical position, even when the unprofessional discarding of the last three years actual salary position is used. So the UUK position is incoherent: they say they cannot afford to pay for pensions, but they can afford to assume a rate of pay increases which is know to be well in excess of what is actually paid. I reminded Ali Tayyebi what the statistical definition of bias is; the evidence is that the assumption on salaries gives a large over-estimate of the liabilities. There are other inconsistencies, and circular arguments, rehearsed again by the actuaries.

Ali Tayyebi also stated that describing uncertainty was a fundamental part of his advice. He had provided numerous different estimates of the deficit, under all the assumptions which we and Imperial College suggested, and many more, to the USS Trustee and the UUK. The USS Trustee has had open discussions with UUK. Bill Galvin said that, to his knowledge, nothing had been withheld which people have asked for. I find this strange, as both institutions (Warwick, Imperial College) and individuals have requested sight of a range of valuations.

Bill Galvin said the range of estimates of the deficit or surplus of USS will be released after the consultation. It seems to us that the USS Trustee and the UUK are withholding important information from members. We do not see how the USS Trustee can claim to be acting for the benefit of members and standing up to employers (two of their statutory duties) whilst failing to provide a range of estimates until after the consultation. In my opinion, I should not trust the USS Trustee to be open, transparent, or willing to respect beneficiaries of the USS.

I cannot find the 'openness and transparency' which was offered. Our replies to the consultation must request sight of the full set of estimates provided by Ali Tayyebi for Mercer.

Jane Hutton"

It is important to realise that it is not really the actuaries who should be engaging in these discussion since their role is to carry out formal analyses on the assumptions that are given to them by the trustee. The same actuary might give a range of answers if asked to consider a range of different assumptions. Also different actuaries might very well give different conclusions if asked to consider a wider range of methods rather than just the conventional one (as has been demonstrated by the First Actuarial report).

So it would have been better perhaps if the meeting had been with some of the trustees. It is they who are taking the decisions (no doubt with advice from Bill Galvin). And they (other than those appointed by the UCU) are paid very handsomely for it.

Dennis Leech : 01 Apr 2015 17:56 |  Tags: Pensions Uss |  Comments (0) |  Close comments |  Report a problem

Very misleading statement by the USS trustee

_{"When I use a word,” Humpty Dumpty said in rather a scornful tone, “it means just what I choose it to mean— neither more nor less.” Lewis Caroll}

_{"Words are a wise man's counters, they do but reckon by them; but they are the money of fools." Thomas Hobbes}

The UUK consultation document Funding background from the trustee is highly misleading to say the least. It contains statements that appear superficially to have a straightforward meaning in ordinary language but are in fact technical in that they require special assumptions for them to be true. Also some statements are downright false. It also has to be said that the trustee's approach to funding raises the question as to whether the trustee is fulfilling its fiduciary duty to always act in the best interests of members. Here are some of my comments.

Valuation and Funding Methodology

The document says:

Since 2011, the deficit has increased significantly and, based on the current benefit structure (ie without taking any account of the proposed changes), the trustee anticipated that it would report a deficit of approximately £12 billion for the March 2014
valuation."

There has not actually been a valuation as yet, by the way. That cannot be done until the changes to the scheme have been agreed. So there is an important element of circular reasoning here, which is rather awkward: the £12 billion deficit depends on members (via the trustee) agreeing to it.

Importantly there is selective use of evidence: the £12 billion figure assumes some changes are implemented but not others. It assumes valuing the liabilities using 'gilts plus' rather than 'best estimate minus' (discussed at length in the First Actuarial report); also 'de-risking': switching from long-term growth investments to lower-return (but less volatile) government bonds. At the same time benefits are assumed unchanged. Both sets of assumptions point in one direction making the deficit bigger and bigger. This is highly tendentious and quite biased reasoning.

Then it says:

... the most significant factor is the change to the assumption which the trustee is making for future investment returns – and the effect of a lower assumption reflecting the changed economic environment – which has added around £7.6 billion to the amount needed to pay pensions."

This does not mean what it appears to say if it is read as ordinary English. The reader might think it alludes to the financial crisis from 2008 on. But investments have recovered since then and the USS investment managers have done well. No. What the trustee means here is how the future pensions promises are valued - a highly technical matter. The USS has to find a figure to stand for a theoretical sum of money in today's terms that would be enough to pay them (assuming it lent securely to the government at low interest rates). Government interest rates - gilts - are not investment returns determined by the market but fixed by the government for reasons of macro economic policy. The term 'future investment returns' has to be understood in this very specific technical sense and is not referring to actual future investment returns that will be earned on the fund's investment portfolio.

This is the nub of the issue. The USS has a large and volatile deficit due to this valuation of liabilities - not poor investment returns. The USS trustee is using extremely low gilt rates for this calculation and not actual investment returns and calling this "the assumption ... for future investment returns".

... it expects those overall returns will be lower given the challenging future economic environment. These assumptions are ultimately judgements which all trustees must make about future anticipated investment returns. These assumptions are reflected in the valuations of scheme liabilities, and in the increased deficits of many defined benefit pension schemes."

What it means by "challenging future economic environment" is that it believes gilt rates will remain low for the indefinite future. The trustee is basing its policy on a myth that currently very low interest rates reflect the "economic environment" notwithstanding that it is being deliberately manipulated by the Bank of England as a matter of policy ("quantitative easing").

The pensions promises that need to be paid have little to do with this "economic environment". Pensions that are to be paid in the future are the same whether interest rates go up or down although they change the valuation of the liabilities a lot. That is why the valuation is inherently so volatile (hence not very meaningful).

The main reason the deficit is so large is that the liabilities valuation increases every time interest rates go down. If interest rates go low enough (and some inflation-adjusted gilt rates are already virtually zero and some actually negative) the liabilities will become infinite. The valuation methodology is fundamentally flawed because it actually breaks down when the discount rate is zero. It is mathematically equivalent to trying to divide by zero.

Life expectancy

The document contains a misleading statement about the pressures due to rising longevity:

Another factor contributing to this increase is the projected improvements to members' life expectancy. The trustee has reported that the changes to the projected life expectancy assumptions between 2011 and 2014 have added almost £1 billion to the amount needed to pay the pensions promised."

This statement appears to imply that there is factual evidence that life expectancy is increasing faster than before. In fact the evidence from the Office of National Statistics tells us that this is not so. But the trustee has decided to increase it nevertheless on the grounds that a survey of other pension schemes conducted by the pension regulator has shown that a majority are assuming a higher rate of improvement in longevity than is evidentially indicated.

So the approach of the USS trustee is to follow the herd. After all, whatever might happen to the USS, nobody could reasonably blame the trustee. They are only following John Maynard Keynes' dictum: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

The de-risking plan versus an ongoing pension scheme: planning to fail?

The document then goes on to say:

Additionally the trustee has carried out some work to update its understanding of the potential financial strength of the sector ... concluded that the scheme's reliance on the sector is considerable and should not grow over time.

The trustee has therefore proposed ... to gradually reduce the amount of investment risk in the scheme - over a 20-year period - in order to maintain the overall levels of risk, therefore reliance, on the sponsoring employers."

This is extraordinary. It means shifting investments from return-generating equities (ie financing investment in real productive capacity by companies thereby helping economic growth) into lending to the government by buying bonds. This is estimated to increase the deficit by £4.4 billion (part of the £12 mentioned above) which is the value of investment income foregone. This decision is to increase the deficit deliberately as a matter of policy and its wisdom is highly debatable to say the least.

The fundamental, overarching risk facing any pension scheme is that there will not be enough money to pay the pensions when they fall due. This new 'de-risking' policy does not necessarily reduce the risk of that happening. Indeed it seems if anything it might increase it. By giving up £4.4 billion of investment wealth it could be seen as almost planning to fail.

The trustee is focussing only on investment risk and ignoring investment return. Yet both are equally important to addressing the fundamental hazard of running out of money. The two need to be looked at together. It could well be that increasing investment in equities and long-term return-bearing assets will improve the chances of the scheme meeting its promises. Many actuaries argue against this kind of de-risking on precisely these grounds. (For example.)

There is also the fact that - as a general principle - this approach is harmful to the economy by leading to resources being diverted out of productive investment.

Is the trustee acting in the fiduciary interest of members?

This policy by the USS trustee is not evidence-based. The thinking behind it seems to be untested financial theory intended to be applied to private companies rather than universities.

Given that they are so controversial it is highly questionable whether these decisions are in the best interests of the scheme. It is certainly not the case that there is solid evidence behind them. The question therefore arises as to whether the trustee is genuinely fulfilling its legally required fiduciary duty. Has the UCU, as the representative of members, considered this? As far as I can see there has been no discussion of the possibiity of a legal challenge on these grounds.

Are universites acting in their own best interests as universities?

The policy seems to be based on the idea that the employer covenant with the universities only has a limited period. This seems an extraordinary idea for pre-92 universities with established reputations, a unique role in society and no reason to think they should not continue. Presumably as with so much else in this dispute it derives from the new idea that universities are businesses just like any other in the private sector and therefore must copy as many of their management modalities as possible. The recent introduction of rigorous line management, with targets defined as metrics, firing academics if they faill to meet short term targets, paying vice chancellors CEO salaries, and so on, are all evidence of the zeal with which universities are embracing what they image to be how businesses behave. Applying the same logic to pensions is more of the same. This is a grave mistake because universites by their very nature are public institutions.

One wonders if the university managements have really thought deeply enough about where they are going before responding to the surveys conducted by the USS and UUK.

Dennis Leech : 30 Mar 2015 10:50 |  Tags: Pensions Pensions; Uss |  Comments (0) |  Close comments |  Report a problem

Suggestions for member responses to the USS consultation

Here are suggestions for USS members to consider for your response to the consultation, in the light of your own understanding of the USS valuations, and the information and mis-information which has been circulated by UUK and the USS trustees. You can then select questions/comments to contribute to the consultation.

It is in your interests - if you care about your pension rights - to respond to the consultation: many members stand to lose out quite substantially. You should also raise these questions/comments with your university management (if you are not at one of the universities such as Warwick, LSE and Imperial College, which have already challenged the assumptions behind the proposals). There is anecdotal evidence that many universities' managements have not really formed an independent view to inform their vote in the UUK but have tended to follow the conventional line. After all, pensions are complicated and difficult to understand.

The UCU head office have circulated some suggested responses. My suggestions include some in addition to those focussing mainly on specific challenges to the valuation, the way it has been implemented and the assumptions that have been made - all of which threaten the continuation of the scheme. I do not believe the scheme can survive for much longer (as a proper pension scheme - that is, a DB scheme) unless the valuation is challenged by members, both individuals and employers. We have powerful arguments: Warwick University, LSE, Imperial College, Actuarial scientists, First Actuarial.

You should also challenge the so-called de-risking strategy which means changing the scheme's investments so as to forego profitable long-term investment opportunities because they are risky in the short term. This is extremely costly and totally inappropriate given the long-term nature of universities as institutions.

Valuation

The key reasons the employers say they want to make changes to the USS relate to the valuation methodology and funding requirement. UUK suggest the scheme is unaffordable, but the reasoning they have given for this so far is not based on convincing evidence. Indeed some of their reasoning is based on unduly pessimistic assumptions about the future, some of which are contradictory. They were found out exaggerating the increases in life expectancy and had to back down.

Comments members might wish to make:

Demand that UUK and the USS management and trustees respond publicly to the arguments made by the actuarial scientists Professors Jane Hutton, Saul Jacka and others in their letters to them. They should also respond in detail to the arguments put by Warwick University, LSE and Imperial.

Why does UUK ignore the actual historical performance of USS investments? USS investments have done well and can be expected to continue to do so (in line with the growth of the economy). Yet USS trustees assume poor investment performance when calculating the liabilities: they calculate the liabilities using a return on government bonds (gilts) rather than the actual investment portfolio which is a properly diversified holding that includes a wide range of assets. They are not required to do this by the Regulator so why do they insist on it?

Why does UUK ignore the actual historical performance of salaries? The trustees' forecast of salary growth is hence much higher than it currently is. This - arbitrary - assumption makes final salary pensions seem too expensive.

Why have the UUK decided that the sector only has a horizon of 17 years? Why do you not accept the Ernst & Young assessment of robust financial health for at least 20 years?

What is the impact on the estimated actuarial deficit and valuation of varying the length of the recovery period to 20 years (and beyond)?


What is the impact on the estimated actuarial deficit and valuation of using an 'ongoing' valuation instead of a 'solvency' or 'self-sufficiency' valuation? The First Actuarial report indicates that this could make a large - even fundamental - difference.

Why was a self-sufficiency valuation used?

Proposals: New scheme and benefits

Closing the final salary scheme is a betrayal. Members have planned their careers on the belief they would receive a pension and lump sum related to their years of service and final salary when they retire, as promised by the USS and employers. It is unacceptable to replace that retrospectively by a link with their salary in 2016. While the Hutton report argued that CRB pensions were fairer than FS, and recommended that pension schemes make the switch, it did not say that serving members should be moved from FS to CRB. It also recommended that in CRB pensions should be indexed to earnings (so that pensioners would benefit from economic growth) not prices (which is what the USS is proposing, linking pensions to the inferior CPI not even the RPI).


What happens to the death-in-service benefit?

What is the current cost of administering the system?

What is the cost of implementing the USS proposals?

What is the cost of DC: 4% is mentioned in the USS modeller, but it is not clear what the denominator is. If employers contribute 12% and employees 8%, a total of 20%, does 4% of salary go on cost of DC?

How will the £55K cap be applied to part-time workers?

How will the £55K cap be applied to casual workers?

Governance and related issues

What are the risks that the new computer system in USS will not be ready by 1 April 2016?

What approach will be taken if the new computer system in USS is not ready by 1 April 2016?

The proposals involve introducing a DC element for salaries over the £55k threshold and cutting back on DB accordingly. Clearly a DC system moves risk to individuals because there is no guanteed pension or 'pot'. Why have trustees supported moving risk from the collective USS fund to individual members? DC schemes are not really proper pension schemes because they do not lead to a pension in the ordinary sense of the word: they produce an uncertain 'pot' at retirement that can be worth little depending on the vagaries of the stock market. Although such pension schemes are being introduced in the private sector they are nontheless unfair. USS as the largest funded pension scheme in the UK is in a unique position to oppose this trend, not join it.

How much of the trustees' time is taken up by the work? We note the Trustees’ payments are in the annual report, pp96-7. [The highest paid in 2013/4 is Carter (£78k), then Harris (the chairman) £70k, Bull (£70k), Holmes (£55k). The UCU trustees donate their fees to charity and do not benefit financially, under union rule.]

You might ask the trustees if they allowed false information on life expectancy provided by the USS group of the Employers' Pension Forum (EPF) to go unchallenged?

Ask your university management: Did you, as a part of [your university name] senior management, allow false information on life expectancy provided by EPF to go unchallenged?

Can [fill in your university name] University accounting systems manage with the requirements of a DC system?

How many of [fill in your university name] senior staff have opted out of USS as their pensions are too large to get tax benefits?

Complaint form

If you as a member wishes to make a formal enquiry about the errors or assumptions, you might find this form useful. Guidance is here.

Dennis Leech : 21 Mar 2015 15:15 |  Tags: Uss |  Comments (0) |  Close comments |  Report a problem

USS issue is fundamentally an intellectual dispute

The USS dispute is primarily an intellectual issue. During the consultation period - when members can have their say about its future - it needs to be addressed as such by the university community.

We know that the scheme is very profitable. It currently makes an annual surplus of over £1 billion after paying the pensions of retired members. There are good grounds for believing that it will probably remain in surplus for at least 20 years. See the First Actuarial report that was commissioned by the UCU. Unfortunately the USS trustees have not carried out this analysis (or if they have they are keeping it secret) and have yet to answer the questions that First Actuarial put to them which would enable us to see the true situation.

Instead they tell us there is a deficit that is not only large but getting bigger (and increasingly volatile). But the methodology they use is highly questionable, being based on untested economic beliefs from the neoliberal faith. It assumes it is possible to assess the health of a pension scheme solely by looking at the market value of its assets (its investments) and estimated liabilities (an imputed figure to represent the pensions already promised) at a moment in time, without needing to worry about the cash flows that are actually needed to pay the pensions promises.

A lot of assumptions are required for this methodology, many of them highly debatable - they are held as articles of faith by the practitioners. The main idea is that 'the market' knows more than any human ever can: specifically it can forecast the future - ergo there is no need for actuaries to bother trying to model the future income and pensions: asset prices contain all information about future investment returns and after some more assumptions are swallowed a valuation for liabilities is calculated as well. These figures are presented without any estimates of error and the difference is called 'the deficit'.

Although these criticisms have been made by academic experts, economists, statisticians, financial mathematicians, actuarial scientists, philosophers and others (both as individual academics and through their institutions, notably LSE, Warwick and Imperial) as well as UCU negotiators, the UUK and the USS trustees will not discuss them. They behave as if their approach is a kind of orthodoxy to which there can be no alternative and refuse to engage in open intellectual debate. They present their opinion as objective fact.

So they have told us that the deficit as of March 2014 is estimated at over £12 billion, but has increased to £20 billion by January 2015 due to unspecified 'market conditions'. In the past, before this mark-to-market methodology was adopted, actuaries used to calculate pension scheme variations over periods of decades reflecting demographic and economic trends. If there was a funding problem it would show up over many years and could be dealt with soberly and responsibly. Yet here we have a massive two-thirds increase in the deficit in a matter of a few months. That should surely show us all that the method is not fit for purpose.

The methodology: requiring all pension schemes to be funded, in the technical sense of assets being always at least equal to liabilities, in order to protect the pension protection fund - was actually made law by the Pensions Act 2005 and associated regulations. Like much Blair-era legislaton it has had dire unforeseen consequences that has led to many workers in the private sector losing their pensions as schemes have closed.

The problem is that the liabilities calculation is not reliable. When government bond rates (gilts) go lower - as they are now under the government's so called quantitative-easing policy the liabilities figure becomes larger and more unstable. That is what is happening - but it has little if anything to do with the actual future pension requirements. Some gilt rates are even so low they are below inflation, hence negative in real terms: when that happens the method would seem to fail.

The fact that so many university managements are unthinkingly following the USS management and going along with this is a real intellectual failure on the part of British universities. They are not doing their job of independent enquiry leading to their taking a view of the true situation - and moreover on a matter that applies to their own material interests where they should have a strong incentive to get it right. It is not the role of universities to simply follow convention, even if some of the negotiators have claimed it to be 'economic orthodoxy'.

The trustees' role is to ensure there will be enough funds to meet the pension payments when they fall due. They means - fundamentally - looking at income and expenditure going forward into the long distant future. That means taking a broad overview - and not relying on the belief that the market provides superior information.

Dennis Leech : 17 Mar 2015 15:03 |  Tags: Emh Pensions; Uss; |  Comments (0) |  Close comments |  Report a problem

The USS agreement is not a basis for a lasting settlement

USS members have been recommended to accept the deal agreed between UUK and UCU negotiators as the best that can be done in difficult circumstances with a widening deficit in the pension scheme. Some people have suggested this is only facing up to the reality that life expectancies are rising and in an economic crisis our investments are not doing very well.

The trouble is that is not a true characterisation of the situation and what is proposed is not a solution that is going to stick. It is not sustainable. In three years' time when the next valuation is due, we could well find ourselves in the same situation again, being told that the career average scheme is unaffordable and must be ended.

Remember that three years ago the changes that were imposed, notably the closure of the final salary scheme to new members, were supposed to deal with the deficit and pay for a recovery programme. We were told the problems had been sorted out. Yet now we are told that the deficit is bigger than ever.

Why did the recovery plan go wrong? There has been no real explanation of that from the USS or the UUK. They have only cited increased longevity - though their life expectancy figures are actually hardly different from those that were used in 2011 - and poor investment returns due to continued low interest rates on government bonds

But on closer inspection a lot more has gone into massaging their deficit figures than that. In the USS circular "2014 Formal Valuation: information for members", published in December in the name of the trustee board, they initially estimate the deficit at £7.6 billion in March 2014, assuming the same scheme rules as in 2011. This figure has been widely criticised for being based on assumptions that are exessively prudent and pessimistic for the scheme, and not based on evidence: such as faster increases in life expectancy than data suggests, high price inflation, and higher salary increases than recently experienced. Astonishingly the USS trustees have been willing to assume two opposite things at the same time: continued recession (manifested in low interest rates and uncertainty about the employer covenant) and economic growth (reflected in high wage and price inflation).

Then on top of that is added a further £4.4 billion in order to arrive at the figure the trustees are quoting. This is to pay for a change in the investment strategy. The plan is to forego long term return from investing in the stock market (with its associated short term risk) by switching the USS portfolio out of equities into government bonds. This, so called de-risking strategy, is turning the economics of pensions on its head, by focussing exclusively on the short term. Normally pension schemes aim to get the best return they can by investing in productive assets like company shares and holding them long-term to receive the dividends (while maintaining a suitably diversified portfolio). That has been the policy of the USS hitherto.

But now the entire focus of the USS trustees is on avoiding the risk that universities might suddenly be unable to keep up their payments at a time when the stock market is down. Hence de-risking and £4.4 billion of foregone investment income. This calculation is strongly based on assumptions the trustees are making about the employer covenant. They have decided that the scheme can rely on strong employer support for 17 years. But after that - who knows what will happen to British universities? So the prudent thing seems to be to assume they will not be able to support a decent pension scheme.

So the figure behind the agreement is a deficit of around £12.3 billion - sometimes rounded up to £13 billion. This figure is not an external fact that has to be faced up to so much as a figure chosen by the trustees through their technical assumptions and investment strategy.

But it gets worse. In their draft paper for the agreement the EPF casually threw in - almost in passing - that the latest estimate of the deficit had risen to £20 billion by January 2015 "due to market conditions". They did not state what these market conditions were that could have such a massive effect - swamping all other other influences - at a time when the stock market is strong and the economy growing.

Such volatility whereby the deficit has increased by two thirds in only ten months is not credible, especially since the whole idea of prudence and de-risking is to minimise risk and avoid volatility.

It seems clear that if the £20 billion figure is going to be believed by the trustees the USS will not last much longer as a defined benefit pension scheme and they will soon be seeking to close it to new members and/or future accrual.

Dennis Leech : 12 Mar 2015 20:04 |  Tags: Uss |  Comments (0) |  Close comments |  Report a problem

Pension regulations' unintended economic consequences

Every private defined benefit pension scheme (including final salary schemes) is expected to be funded at all times. That means having enough assets to cover the liabilities there and then if need be. The idea is that if something awful happens to the sponsoring employer the scheme can be wound up in an orderly fashion. It is solvent and all the pensions can be paid from the money raised by selling the assets - notionally at least.

If there is a deficit its trustees have to put in place a recovery plan requiring extra contributions by members and employers.

This regulatory regime is partly enshrined in the law, partly the convention that now places a large emphasis on avoiding all sources of risk wherever one can be identified. This protects the Pension Protection Fund from claims but it has unfortunate wider economic consequences. It affects both long term economic growth and short term cycles.

The system of regulation focuses entirely on short term risk and volatility. Pension schemes traditionally used to invest for the long term to get the best returns. Now they are advised to avoid the short term volatility inevitable in such investments. This leads to a short-termist mentality that is harmful to economic growth.

Yet 'short-termism' has long been recognised as one of the main problems with the UK economy. Governments have tried to address it by various initiatives, most recently by the Kay Review of UK Equity Markets and Long Term Decision Making. Pension funds have a key role to play in supplying long term capital but they are being given incentives not to fulfil it for example to 'de-risk' their investment portfolios by switching from equities to government bonds.

The second unintended macro-economic effect of the funding regime is that funds are in deficit and have to make extra payments during a recession. Currently (February 2015) the combined deficit of all DB schemes stands at over £300 billion. This is treated as a gap that has to be filled as soon as practicable by a recovery plan to increase savings into the scheme. These payments come out of company cash and wages and so are a subtraction from effective demand. This is a substantial sum: the latest figure for deficit reduction payments is £25.6 billion to reduce deficits for the 2014/15 year.

Thus the regulatory regime is a pro-cyclical factor that makes recessions worse.

Dennis Leech : 23 Feb 2015 14:31 |  Tags: Austerity; Pensions |  Comments (2) |  Close comments |  Report a problem

Misleading pensions story in the Telegraph

Yesterday's Daily Telegraph headlines an article entitled Final Salary Pension? Your retirement income is at risk.

It provides figures provided by the Pensions Protection Fund for all private final salary defined benefit pension schemes showing assets of £1,200 billion and liabilities of £1,500 billion giving a shortfall of £300 billion.

(The actual figures for February 2015 are £1,273.8 billion of assets and £1,641.2 billion of liabilities.)

For a number of reasons this calculation should be treated with a big pinch of salt.

First, these figures are capital sums and bear only an indirect, theoretical relation to the actual pensions that require to be paid in the future and the money available to pay them. As a matter of elementary economics, pensions cannot be stored up to be drawn down later when we retire. Pensions are received as income when they are required and paid out of expenditure by pension schemes. So the assets/liabilities comparison is problematic.

Any variation in asset values has little bearing on the ability of the pension scheme to meet the actual payments of money to pensioners required. In the same way if your house goes up in value that does not automatically mean you have more income - you have to sell it or mortgage it etc before you can convert it to an income - there are extra stages to go through which are not necessarily simple. The link between a pension scheme's asset prices and the pensions it can afford to pay is not direct.

Second, they are calculated on different bases and their comparison is misleading. Asset prices are valued at market prices on a particular day. Penson liabilities are a theoretical amount that would have to be lent to the government assuming the continuation of the current recessionary conditions and historically very low interest rates for ever into the future, and also making the most pessimistically prudent assumptions about trends in life expectancy, future inflation, wage growth and so on. Thus some might think it prudent to assume salaries will grow rapidly (suggesting a belief in economic growth) while interest rates will continue at currently recessionary levels. Some might question the wisdom of assuming two contradictory things at the same time. This is central to the USS valuation.

Third, these figures are both very approximate and should come with a wide margin of error attached. It is puzzling that it is not considered appropriate for the Pension Protection Fund to provide us with such error bounds. It can't be hard to do. The deficit figure being the difference between two such large magnitudes therefore has a much larger margin of error. (This is elementary statistics.)

Fourth, the figures are very volatile. The assets are volatile because their prices go up and down with the stock market. Stock market prices reflect all sorts of influences and not just the rational expectations of investors: political, psychological, institutional factors are just as important. Herd behaviour, speculation, the effects of financial derivatives and Rumsfeldian unknown unknowns cause asset prices to be far more volatile than the income those assets might yield.

The liabilities are even worse. Small changes in discount rates exert a strong effect and cause huge volatility. And remember that the actual pensions that are paid to retired people are defined by the rules of the scheme. They are not affected at all by changes to government bond rates. So any changes for example due to Quantitative Easing are completely irrelevant - so why base the calculation on them? The calculation only makes sense under very particular and not very realistic assumptions about the economy.

The figures for the deficit are thus so volatile as to be misleading.

Fifth, the figure for the deficit seems so large as to be frightening. Some commentators are fond of saying that public sector pensions liabilities (such as for the TPS) represents additional unfunded public debt and therefore the true level of debt is much larger than we suppose. This is a wrong argument because government pensions like the rest of public sector salaries are part of current spending out of taxation. This exaggeration of the scale of debt is really scaremongering intended to frighten people into accepting detrimental changes to their pension rights. Pensions are actually deferred pay.

Unfortunately this method has been enshrined in the rules and the legislation. That does not mean we should not question it. There are many instances of bad laws being enacted and subsequently changed.

Dennis Leech : 22 Feb 2015 03:51 |  Tags: Pensions;Uss;Tps |  Comments (0) |  Close comments |  Report a problem