May 08, 2016

Misleading Times article about pension deficits

An article in last Saturday's Times, 'Universities' pension scheme could face their most rigorous examination' is an object lesson in the poor standard of reporting on pensions. Its author, Philip Aldrick, is the paper's Economics Editor, yet he displays a poor understanding of the underlying issues he is reporting which leads him to mislead the reader.

He is telling us about the large deficit that is being forecast to emerge from the next valuation of the USS, the private pension scheme that covers staff of the older universities, what are known as the pre-92 universities. The newer institutions, mainly the former polytechnics, are covered by the teachers' pension scheme, guaranteed by the taxpayer. But the USS is private so it comes under the same regulations as company pension schemes, such as the BHS.

But there the comparison ends. Questions are being asked in parliament about where the BHS pensioners' money has gone: there are some fairly simple and obvious question marks surrounding the role of the former owner of BHS, Sir Philip Green.

The USS deficit is not like that in that it is not clear where the deficiency is or how it has arisen. We cannot blame anyone for taking too much money out. We are told that at the last valuation in 2014 there was a deficit of £5.3 billion and that a recovery plan was agreed involving cuts to benefits and increases in contributions which were designed to fill the gap. Yet only a year later the deficit had become £8.2 billion. And it is estimated that by the next valuation in 2017 it will have ballooned to £11 billion.

These changes have taken place with nothing substantial changing in the actual scheme itself: there has been no Robert Maxwell raiding the pensions pots of his employees, no university finance officers indulging in creative accounting, no sudden mass retirement of thousands of senior professors on high final-salary-linked pensions, no sharp drop in recruitment. On the contrary changes in pension scheme deficits on the scale reported would only normally be expected to occur over perhaps a decade or longer, not a period of months. And they would be explained in terms of tangible factors such as increased longevity. But forecast longevity does not increase in big sudden jumps on the scale needed to explain these deficits.

No. These big swings in the deficit are almost entirely artificial. They are due to the regulation rules which have an inbuilt bias towards finding a deficit. This is is a problem that affects all defined benefit schemes: USS is merely the largest and therefore the effects are greater.

Many of the pension deficits stem from a major mistake by the government in basing regulation on what is called ‘modern finance theory’ or ‘financial economics’. Pension schemes have to be valued in terms of assets and liabilities, which are categories of capital, when what actually matters is whether the flow of income is enough to pay the benefits into the future. Capital values and income flows are two completely different things. It does not matter what the prices of the scheme’s investments in shares are on a particular valuation date; what we want to know is how much income those shares are likely to bring while they are held in the portfolio.

Theory teaches us that the capital value of an asset is the discounted present value of the expected net income received by its owner. That theory is the basis of valuation required by the pensions regulator. But we should not listen to that theory because it does not hold in practice. In reality share prices are highly volatile, far more so than the economics supposed to underly them. The asset valuations are far more volatile than the dividend and other income as a result of natural speculation in the stock market and other reasons like sentiment, 'irrational exuberance', and so on. There is massive evidence on this. There is a wealth of literature showing that excess volatility exists and that it is large; some studies have found it to be an order of magnitude greater than the volatility attributable to underlying economic events.

Yet the legislation on valuation of pension scheme assets requires it to be done in line with finance theory: by pricing to market and taking the ensuing volatility as risk and therefore something important to be managed. If anyone points out that there is excess volatility in the real world, it is dismissed as a merely a 'puzzle'.

The liabilities, too, have to be estimated in a way that makes it possible to compare a figure for them with the assets. (This is where the 'complicated mathematics' of the article comes in: Mr Aldrick reveals he is not well-up on pensions economics when he sneers at this.) The liabilities figure is an even stranger concept than the assets. And this is where most misunderstanding comes from. Most journalists do not understand how artificial and divorced from reality the liabilities figure is.

Under the rules the trustees of a scheme have to work out a hypothetical capital sum that - if it were invested in a certain way - would produce the assumed future benefits. The regulations actually allow for quite a lot of discretion in how this is done but most actuaries have got the idea from finance theory that investing in gilts is risk free. The problem with this is that gilt rates are very low at present so this means liabilities are very high. And as gilt rates change by a small amount the liabilities change massively by billions. (It is not a risk-free rate if it is constantly changing.) Yet the real liabilities are the benefits that have to be paid in the future and have not changed, they are just the same. Once again it is theory in the face of evidence: real pension schemes do not invest in gilts but in assets that will give a high return, in a prudently diversified portfolio.

The third major factor is the employer covenant. When USS was set up it was backed by the government. Any deficits could be made up by changes to the grant. The UGC (later HEFC) had a seat on the Board. So institutions did not have to worry about risk of the scheme failing. But the government (Willetts I assume) withdrew in 2011 and the scheme, as the article says, is a last-man-standing scheme. This seems to be exercising the minds of some of the employers worried about taking on the liabilities for institutions that fail in the new competitive environment where we are being under-cut by cheap new entrants. So the valuation - I believe - currently assumes only a twenty year covenant: to be on the safe side universities are assumed not to contribute beyond that. How likely is it that institutional members of the USS - the pre-92 universities mainly - will go bust.

Members are having to contribute more and more to the scheme, and benefits are being cut, in order to manage a lot of synthetic risk in the form of market volatility which is not the same as actual risk. On top of that they are having to pay to manage the risk of institutional bankruptcy.

Mr Aldrick finishes with an extraordinary comment: "The big hope is that interest rates rise which, through complicated mathematics, will reduce the liabilities. If that is the plan, however, it would make Sir Philip look as clean as a whistle. Universities, we'd like to think, measure themselves by a higher standard."

This statement suggests he does not appear to get it. He does not seem to understand that the reason that the liabilities figure is so large is mainly due to low interest rates but instead seems to believe the deficit is real and that the effect of a rise in interest rates 'through complicated mathematics' is somehow an extraneous technicality that might be as morally dubious as the shenanigans at BHS. The fact that interest rates are low is the reason the deficit appears so large.

- 2 comments by 1 or more people Not publicly viewable

  1. Tim Bates

    Glad someone is writing about this. But are you arguing that the stock market is undervalued, by a great deal, and is more undervalued than in 2010? Not many would agree.

    Seems more likely that our scheme was improperly costed from the start.
    More likely that this was not addressed because it has been in the interest of people retiring at any date prior to 2020 (when things appear to be coming to a head) to keep their own contributions to a minimum, and retain the ability to have their own pension based on a final year bumper pay.

    What most concerns me now that young members are locked into making up this deficit (already-retired folk’s pension income and increases being unchangeable by law), that the fund is managed well.

    But I can’t find a single statistic on USS choices of stocks, or funds. Nor any comparative retun tables.. they would help understand whether the fund is managed well or not.

    Best, Tim

    08 May 2016, 18:10

  2. Dennis Leech

    I am not saying the stock market is undervalued. I am saying that the fund is having to make large ‘recovery’ payments to compensate for the volatility of the stock market investments. The reason for that is that this volatility is interpreted as risk against all the evidence. The market price of a share fluctuates a lot. The question is why should that be. Theory says it is simply a reflection of the rational behaviour of investors who can foresee how the firms concerned will behave into the far distant future, at least on the average. So there are never speculative bubbles and crashes – all volatility is due to changes taking place or expected to do so in the real economy. Empirical evidence says that bubbles and crashes occur periodically because of herding or bounded rationality. See for example the work of Robert Shiller: he demonstrated ins long ago as 1981 that stock market prices are many time more volatile than the theory says they should be.

    This is important for the valuation of the pension scheme because one of the criteria underlying the recovery plan is that the probability of having to increase contributions should be fixed. Volatility measures (i.e. standard deviations of portfolio values) are important in doing this calculation. If we were able to use a measure of the true risk which is smaller than the volatility then the recovery contributions would be a lot less.

    I do not believe the scheme was improperly costed. What has happened is that there has been a revolution in thought among much of the actuarial profession under strong pressure from regulators – so that they have been persuaded to base their valuations on mechanical rules taken from finance theory without thinking about the macro- economy. If there is a criticism of the design of the USS it is that it is over-concerned with inflation protections because it was introduced in a period of high inflation in the 1970s.

    Final salary schemes are actually inherently sustainable because the benefits, being proportional to salaries, and salaries increasing with economic growth generally, tend, by and large, to move in step with economic growth. Likewise the income to the scheme from contributions – which are proportional to salaries – and investment income from dividends all tend on the average to growth with the economy.

    You can see the USS investments on their website. It lists the top 10 investments by capital value and also the names of all companies in the portfolio. They do publish information on performance but in a way that is difficult to compare. There is information in the annual report on the rate of return on investments and they tell us that they have exceeded their benchmark.

    The problems with the USS are not poor investment returns but – as with every other DB scheme in deficit – poor regulation based on an almost religious belief in the perfection of free markets and a rejection of real-world evidence. In a sense the world of the pensions regulator is the most neoliberal in the economy – Thatcher’s dream.

    08 May 2016, 20:00

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