April 30, 2018

The Joint Expert Panel will fail unless it is both radical and transparent

The agreement between the UUK and UCU provides that a “Joint Expert Panel, comprised of actuarial and academic experts nominated in equal numbers from both sides will be commissioned to deliver a report. Its task will be to agree key principles to underpin the future joint approach of UUK and UCU to the valuation of the USS fund.” If it is to achieve anything worthwhile it must carry out its task in a transparent manner.

The panel’s job will be to get at the truth against opposition from the vested interest of the USS executive who seem committed to a particular controversial view. The only way it can succeed in doing that is for it to proceed on the principles of free and open academic enquiry. Otherwise it will end up just rubber stamping what the USS is saying.

Let’s not forget that the scheme valuation according to the USS has not just been sprung on us. UUK and UCU, and their advisers and actuaries, have been discussing the draft valuation for months, if not years, since at least before the last valuation, for March 2014.

The UCU has been robustly challenging the methodology being followed by the USS, and many of its key assumptions. But it has been brushed off by Bill Galvin, the chief executive, and his executive team, without them seriously engaging with the arguments, while the Directors, in whose name they act, have remained silent, at least in public. It is to be hoped that some of them speak out against this one-sided approach, if only in board meetings.

If it is to do its job properly, the JEP needs to be radical, to address fundamental issues and ask basic questions. It is not enough just to hold a couple of meetings, listen to evidence behind closed doors and then issue its findings. It needs to transparently set out what its agenda will be in terms of “key principles to underpin the future joint approach of UUK and UCU to the valuation of the USS fund”. Only then, and if it openly publishes the detail of how it will do that, and is seen to subject the flawed USS approach to a radical re-appraisal backed up by evidence, will it satisfy members.

Issues for the JEP agenda

1. Accountability to members. The latest videos put out by the USS, featuring the CEO Bill Galvin, head of risk Guy Coughlan and scheme actuary Ali Tayyebi, fail to provide a satisfactory account of why changes are necessary and prompt questions about accountability. The Pension regulations state duties of a trustee in terms such as: “... ensure their pension scheme delivers good outcomes for members' retirement savings”; “Trustees must act in the best interests of the scheme’s beneficiaries”. It is arguable that the USS executive and trustees are falling short in their duty to the members.

2. Need to follow actuarial guidelines Actuarial guidelines say trustees “ ... must choose a method for calculating the scheme’s technical provisions, ie the value of benefits accrued to a particular date. You must take advice from the actuary on the differences between the methods and their impact on the scheme.”

The USS are not doing that because they are failing to properly consider different methods which give a different picture. This is not just of academic interest; there is a wide gap between what we are told by the USS executive and what makes sense to, for example, an intelligent person, whether a specialist such as an economist, statistician, or non-specialist, using a different method. They are doggedly working to a fixed blueprint and failing to consider alternatives which may benefit members.

The JEP should therefore insist that the USS executive be required to give a rounded view (ie taking into account analyses from different angles) of how the scheme is doing, and do so in simple language. They present only a single - relentlessly negative - view that clashes with the fact that the scheme is not in deficit in the ordinary sense of the word.

3. Need to explain the deficit. The overriding requirement is to require USS executive to explain how the present - apparently quite large - annual cash surplus of over a billion pounds per year turns into a deficit. Although this question has been asked many times by the UCU, so far no response has ever been forthcoming. Instead we just get a sort of financial hocuspocus. We need to know if there is really a deficit in a practical sense or it is merely a cconsequence of a particular theoretical approach lacking a sound empirical basis.

4. USS is a special case. The JEP should recognise that the USS is an extremely large scheme covering an important sector of the economy, one that provides vital public services. It is therefore unacceptable that it be managed solely according to a template intended for commercial company pension schemes. The scheme should be reviewed and valued in a manner that recognises the specific features of the pre-92 HE sector. It is not a typical company scheme and should not be compared with other DB schemes in a superficial or simplistic way (as the scheme actuary does in the video). Higher education should not be thought of as run in the same way as Woolworths.

5. Get power relations right. It is important that the JEP terms of reference have a proper regard to the power relations among the parties. The stakeholders are the UUK and UCU. The UUK institutions are the sponsors and therefore the senior partners. They ultimately call the shots. The USS board is accountable to the stakeholders, who appoint its members. They also employ the executive.

6. Role of the Pension Regulator. The regulator’s role, as a government body, is to ensure proper governance of pension schemes. It cannot and should not be taken as a substitute for the trustee and sponsor. The pensions regulation system is designed for (mostly small) schemes involving a single company in the market place. The university sector is quite different, and big and important enough not to be dominated by the regulator. Also it must be remembered that the pension regulations give trustees and sponsors wide discretion on many aspects of the valuation.
 The rules as not as strict as we are often told and the regulator uses its enforcement powers only reluctantly.

7. Strength of covenant. The JEP should thoroughly and seriously examine the strength of the employer covenant, that is the ability and capacity of the 300 plus employers, including 68 pre-92 institutions, collectively to support the scheme. The scheme should be seen as one covering a whole large and important sector of the economy, which is more resilient than the mere financial solvency of the current members of the USS. The activities of teaching and research that are the business of the members are not related solely to the existence of particular institutions, and the need for them will continue after an insolvency, requiring the continued support of a pension scheme.
 So it is wrong to look at covenant exclusively in terms of the solvency of individual institutions without considering the pre-92 sector as a whole.

8. Take a long-term view. Pensions are long-term commitments and funds ought to be invested on that basis. The valuation should also take a long-term view and ignore short-term fluctuations in asset prices. Short term market volatility is of minor, if any, relevance. Keeping the scheme open to new members is key. An open scheme with positive net cash flow can invest in assets that have a high expected return in the long run, such as equities. The efficient and rational running of the scheme suggests this.

9. The assessment of the covenant should beware circular reasoning. The discount rate used in the valuation reflects the strength of the covenant: where there is a weak covenant, prudence leads to a high liabilities figure based on a low-risk gilt rate being used as the discount rate. So it is circular to then use this liabilities figure in asking about the employers’ capacity to support the scheme, that is, whether the covenant is strong or weak. That is putting the cart before the horse: the assumption of a weak covenant leads to the conclusion that the covenant is weak.

Equally, basing the discount rate on an assumption of a strong covenant, giving the scheme freedom to invest in higher-return higher-risk assets for the long term, a higher discount rate and hence lower liabilities, might lead to the opposite conclusion. Assuming a strong covenant and valuing the liabiities on that basis might very well point to the employers being well able to afford to support the scheme indefinitely. The present covenant assessment method assumes the result it sets out to find and is not fit for purpose.

10. Further detailed questions. The JEP should require answers from the USS actuary and executive to questions of detail. It should not be satisfied with generalisations presented without evidence, which is their usual style.

Members should ask for further detailed information as follows: 

(a) Analysis of the scheme in terms of cash flow projections for income and outgo. Preliminary studies based on partial information done by First Actuarial have suggested strongly that the scheme is long-term sustainable over a range of assumptions. More work needs to be done, building on this, using the actual data from USS.

(b) Question the excessive use of index linked gilts (which are currently producing a negative return). The idea that investing in government bonds - following actuarial habit from a time when such assets provided a steady and safe return - should be questioned in light of today’s very low interest rates that result from government policy. It is highly irrational to invest in a way that guarantees losing money - money that will have to be found from higher contributions. The notion that such an investment strategy is a ‘safe harbour’ (as Guy Coughlan puts it) needs to be subjected to detailed scrutiny. Is the scheme actuary just following the customary practice, not noticing that its rationale no longer exists?

(c) Why not use the internal rate of return? Every pension scheme has an implicit internal rate of return required for its investments for it to be sustainable. It would cast a lot of light on the scheme and answer fundamental questions around sustainability if these could be provided and compared with actual and expected rates of return.

(d) Are investment returns in fact too low? The USS executive claim that expected investment returns have fallen too low for ‘most asset classes’. It is certainly true of gilts. But is it also true of higher income assets such as equities? The JEP needs to examine this argument carefully, because, even if expected returns have fallen, that may make little difference to affordability in practice - if discount rates are based on investment returns not gilts - especially if the scheme is in surplus.

(e) Investigate in detail the ‘best estimate’ valuation. The USS valuation document reports a ‘best estimate’ surplus of £5.1bn. Their statement that ‘the best estimate surplus has only a 50:50 chance of success’ need to be examined since it seem to be lacking in precise meaning. This 50:50 argument comes from the fact that the liabilities estimate is an average (median) over the distributon of investment-portfolio-return-based discount rates, but that in itself does not seem to tell us about the likelihood of the surplus not being achieved.

(f) Focus on the income from the investments not their price. This is a major issue that seems to be almost universally ignored in pension valuations. The fact is that the stock market and bond markets are much more volatile than the income that drives them - whether dividends or interest - well known from the work of e.g. Shiller and others. This excess volatility greatly amplifies risk if assets are valued at market prices. A true economic analysis would allow for this but it is being ignored by the USS executive. In an open scheme like USS it is income from investments that are important to pay the pensions and their asset prices are of minor importance.
 Valuing the scheme using asset market prices instead of investment earnings greatly amplifies risk. The JEP should commission an alternative valuation along these lines, with assets valued at discounted present value of expected future income.

(g) Question the facile assumption that equities are universally riskier than bonds. This assumption leads to statements being made with an undue degree of certainty and calculations done with spurious precision. Many equities provide good long-term investments without a lot of risk. Bond markets are also subject to short-term volatility like equity markets and there is excess volatility in both.

(h) Examine in detail projections of key parameters including mortality rates, salary growth, inflation, etc. Also the level of prudence.

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