March 10, 2023

David Miles' Response

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

Dear Dennis

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

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

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

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

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

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

All best


David Miles, CBE

Professor of Financial Economics

Imperial College

South Kensington Campus, London SW7 2AZ

T: +44 (0)207 594 1292

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