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
combination.

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
contributions.


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)


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