August 26, 2019

The USS dispute is not about cost sharing but the survival of defined benefit pensions: a rejoinder

What is at stake in the USS dispute is the survival of defined benefit pensions.

The UCU negotiators have repeatedly shown that there is no need for contribution increases or benefit cuts, that the scheme as it currently exists can continue in existence indefinitely provided it is managed in a way that seeks to make that happen. The reason is that it is a multi-employer scheme designed for a unique sector, the pre-92 universities. The pre-92 universities not only provide world class scholarship, research and education but, as a sector, can be seen as one of the UK’s most successful industries. That should be at the front and centre of all discussions about the USS: its unique nature means it has very little in common with other private sector schemes and should not therefore be compared with them.

Unfortunately the USS Employers in their latest response to the UCU have demonstrated that they are not engaging with that view and give no indication of their intention to do so. Their letter is full of innuendo and half-truth and does not deal with the arguments. It underestimates the intelligence of university staff and many will feel insulted and devalued by it.

The choice for the USS is between two possible alternative courses:

(1) that it continues to be an open ‘defined benefit’ scheme that provides guaranteed pensions based on salary and years of service, on an ongoing basis with an indefinite time horizon, open to new members, supported by a strong employer covenant that is continuously monitored; or

(2) that, in common with most private sector company schemes, it may decide that the various risks of staying open are too great, and do what they have done, close to further accrual, with consequent increases in contribution rates, as was proposed last year. New members will be offered an inferior ‘defined contribution’ plan that does not lead directly to a solid pension but uncertain benefits. Employers will take advantage of this change to cut their contributions as well as transferring all the risk.

These two alternatives require the scheme to be viewed in different ways that lead to different investment strategies and different ways of managing risk. And two different valuations. Any decision about the future of the scheme requires a comparison of both.

If the scheme is assumed to remain open, as in alternative (1), providing that there is positive cash flow available for long term investment, in a suitably diversified portfolio that includes high return assets such as equities, there will be healthy income to pay pensions in the future. The main source of investment risk - short term asset price volatility - can be managed. Since the pension payments are long in the future, it is long term investment returns that matter, and short term volatility can be ignored.

In fact in an open ongoing scheme that is cash flow positive like the USS, any downturn in the stock market is an advantage, not a threat - because it means assets can then be purchased more cheaply, reducing the cost of future service accrual.

The valuation of an open scheme ideally requires a comparison of projected income flows with projected outgo in pension payments. The UCU have repeatedly asked the USS to carry out such an analysis without one having yet been published. Our actuarial advisor First Actuarial have provided such analysis that strongly points to the scheme being sustainable. It would be good if the UUK joined us in demanding the USS carry out a similar analysis using the complete data set that they have available.

Alternative (1), of course, depends on there being a strong employer covenant. The covenant risk to the scheme is essentially the insolvency of all the pre-92 universities. The risk from insolvency of individual institutions is offset by the collective nature of the scheme, so called ‘last man standing’. The risks facing the scheme are essentially those facing the pre-92 higher education ‘market’ as a whole. That does not seem a likely prospect at the moment. If that begins to change it will be noticed in the periodic review of the scheme and in the triennial valuations. It does not seem realistic to assume it will happen suddenly without warning.

Alternative (2) is the only one that the USS employers, executive and most of the trustees seem to be willing to countenance. It denies the unique nature of the USS as a sector scheme and treats it as if it were a mature single employer scheme. It assumes the scheme matures and then the job of the trustees is to manage the ensuing runoff. The whole emphasis is on risk rather than return, making sure the invested funds can pay the pension promises with absolute certainty. Paying the pensions depends on the investments being risk-free which means investing in government bonds.

The problem - and the source of the dispute - is that government bonds are no longer a good investment. Twenty years ago they would have produced a return of perhaps 2% above inflation but today, thanks to post-crisis monetary policy and quantitative easing by the Bank of England, the rate of return after inflation is negative.

Yet the policy of the USS, supported by the UUK employers, ignoring the thinking of the Joint Expert Panel, of so-called de-risking, is to invest in assets that are guaranteed to lose money. This is regarded as a low risk strategy on the grounds that the loss is certain. This is surely an absurdity. De-risking actually increases the risk to the scheme that it cannot pay the pensions when they fall due because the loss on the gilts has to be paid for by the members and employers. This is what is driving up contributions and threatens the survival of the scheme.

It should be noted also that interest rates on government bonds are no indication of investment returns more generally. The expected long term return on equities and other forms of patient investment in the productive economy (rather than lending to the government) continues to be sufficiently high to pay the benefits.

Essentially the defined benefit scheme is being undermined by the herd mentality group think of the pensions experts in the USS executive. They are applying thinking from the past - when it was rational for pension schemes to invest in government bonds that produced a steady though modest return as part of its risk management - to today’s conditions of negative risk-free rates. It is an example of how real damage to people’s welfare can result from the continued unreflective use of an economic model when the conditions for its application do not hold or have changed.

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