March 16, 2018

Reply to Sally Hunt

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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.

- 3 comments by 0 or more people Not publicly viewable

  1. Catherine Donnelly

    Nice response, Dennis. The current fashion for DB pension schemes to eliminate investment risk means that they aim to pay pensions no matter what happens. However, this has a high cost: it means investing in low risk, but low expected return assets such as bonds. It also just creates different kinds of risks for the ex-members as they are shunted into DC.

    Yet the DB schemes have decades-long investment horizons. What ‘prudent person’ would invest in low return assets over such time horizons? No default DC fund does.

    Perhaps the ‘old’ assessed value approach for DB scheme valuations need to be considered again.

    16 Mar 2018, 13:06

  2. Andrew Chitty

    Thank you for this.

    I think you are right that the agreement of 12 March is at odds with itself. It takes as its premiss the November 2017 valuation in coming to a settlement about how the costs of recovering from the ‘deficit’ produced by that valuation are to be shared and yet sets up an independent review to assess the soundness of the methodology of that very valuation. Both UCU and UUK have tied themselves to this contradictory stance. UCU needs to untie itself by saying that in the light of reflection and consultation with its membership it recognises that no joint conclusions in action can be drawn from a valuation whose methodology is accepted to be suspect. Therefore its revised position is that the USS scheme should remain unchanged pending the proposed independent review. From the signals sent by UUK and the Regulator since the shock of the UCU membership’s next-day rejection of the agreement, I suspect that they are open to such a position.

    Of course as you say everything then hangs on the composition, methods, and transparency of the independent review. This would be the next battle to fight.

    16 Mar 2018, 20:38

  3. Stone Elworthy

    I totally agree with the thrust of your argument but I can also see how UUK consider that the pension deficit undermines the strength of the covenant in a vicious circle. That is only the case because some Universities have saddled themselves in debt with PFI type schemes. Those universities could face more expensive refinancing costs if the pension deficit is seen as an issue by their creditors. I suppose that is what is at the heart of this whole fiasco. I totally agree that we’d hope that no UK government would allow its University sector to go bust. But we have an iffy mess where Universities can get more and more embroiled in PFI type debt (and use new fancy buildings and facilities to try and complete against each other) and just cross their fingers and hope that everything will be backstopped by a government bailout if push comes to shove.
    Perhaps the best hope for a resolution would be if USS were taken out of the control of UUK and instead administered directly by the government. If USS is anyway relying on the assumption that the government would backstop things, then that might as well be made explicit.

    24 Mar 2018, 07:55

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