November 05, 2014


Frequently Asked Questions about the USS

What is the deficit?

The word ‘deficit’ normally means the amount by which income falls short of spending.

That is not what is meant here. The USS is actually in surplus in the normal sense. But the term ‘deficit’ is being used as a technical term to mean a balance-sheet shortfall between the liabilities and the assets. This is a theoretical stock of capital rather than money that necessarily has to be found in the ordinary day-to-day business of things.

It is a bit like negative equity on a house. If house prices fall many people will find their mortgage debt greater than the value of their house: a situation known as negative equity. That happens fairly often and is not usually regarded as a problem that has to be dealt with. We see it as merely a temporary situation until house prices recover in the normal course of the economic cycle. It does not mean that the householder has to suddenly find the money to pay off the difference.

Another analogy might be the national debt. It never has to be paid off and causes no problems as long as the government can pay the interest, something it has never been unable to do.

But we are being told the USS pension deficit must be paid off as soon as possible regardless of the state of the economy. It is rather as if your mortgage lender was telling you to find the cash now to pay off your negative equity in an emergency recovery plan.

The UCU is contesting the valuation methodology. How is it possible to do that if the law is clear that pension schemes must be valued every three years?

Things are not black and white. There is not a single natural way of valuing a pension scheme. Any valuation depends very heavily on economic theory, and there are different theories about what a pension scheme is. The law allows for different approaches to be used. However the regulator, many actuaries, trustees and accountants tend currently to be taking an approach that would at one time have been regarded as overly prudent. Prudence can be taken to extremes such that instead of leading to a cautious appraisal, the survival of the pension scheme itself is threatened. This has been dubbed ‘reckless prudence’.

Traditionally the actuaries used to take a long term view taking account of the likely income earned by the investments in the future in relation to the pension promises. This would allow for temporary effects due to the inevitable economic cycles. This approach (known as smoothing) is not allowed to be used under the rules that are being applied now. Valuations must be based on an ideal theory that markets are efficient and no judgement or forecast can be any better than that of the market. So actuaries cannot take a view in the way they used to do. Essentially there is no room for macro-economics any more. There is only the micro-economics of the efficient markets hypothesis. But the efficient markets hypothesis is contested by economists, actuaries and accountants. The fact that this approach is being effectively imposed is market fundamentalism, based on a neoliberal world view.

How are the assets valued?

The law states that the assets of a pension scheme must be valued at market prices. There has to be a valuation every three years on March 31. The theory behind this is that the assets are the fund out of which the pension promises are paid. But for a very large scheme like USS that is not a very practical concept because it is not possible to sell large quantities of assets (currently about £40 billion) without causing a crash.

But it is not really market prices that matter so much as the income that the investments will bring. Earnings from dividends, interest, rent and so on are what are important. Yet these are ignored.

The idea of using the market prices of the assets to assess the health of the scheme comes from a particular economic theory known as the efficient markets hypothesis that holds that the market price of an asset reflects all future information about the earnings the asset can yield. So it is not necessary for the actuaries to forecast the future income because the market – as if by magic - has already done the work for them. This is an elegant theory with very little if any empirical support. In fact all the empirical evidence shows that asset prices are very much more volatile than earnings from dividends etc. These fluctuations in asset prices reflect short-term macro-economic and political conditions external to the scheme and are not directly relevant to the solvency of the pension scheme in the real world.

How are pension liabilities calculated?

The liabilities are the most problematic part of working out the funding position, because the liabilities are long term promises of pension benefits into the distant future. The methodology relies very much on economic theory and produces a figure that is not only highly volatile like the assets but also the methodology behind it is highly questionable anyway. The figure derived for the liabilities only makes sense under very strong and unlikely assumptions.

The idea is to calculate what would be a suitable sum of money that would enable all the pensions promises to be paid on the assumption the scheme were wound up. That is the theoretical basis.

This requires an assumed notional rate of interest known as the discount rate. We are told that prudence dictates that we cannot assume interest rates will every again increase above their current very low level. The economy will never recover. Also prudence dictates that we assume the worst about life expectancy, future inflation, future pay rises, and so on. Thus we must assume that pay continues to rise faster than inflation (despite recent experience to the contrary) yet the economy does not grow at anything like that rate. Also we are told by the EPF that life expectancy is growing at something like almost six years every decade despite evidence from the Office of National Statistics that it is more like less than two years.

The economic model that drives thinking on this is where the pension scheme belongs to a company that might go bust (or maybe the chief executive might steal all the pensioners’ fund then commit suicide as happened with Robert Maxwell at Mirror Group). In the case of the USS it is a group of universities.

But the USS is a huge scheme covering an industry rather than a firm. This model does not fit the reality.

It is said by many critics that the USS is very poorly managed. Isn’t the problem that the scheme does not invest its fund well?

No. This is often said but the criticism is unfair. In fact USS investments have been performing relatively well. Not perhaps the best in the industry but certainly well above average. Last year the USS made a rate of return of 7.6%, 1.4% above its benchmark:


The USS is often criticised for having invested in the wrong sort of assets. It is heavily overweight in equities which are risky and it needs to rebalance.

This argument has been around for a long time and has never been rebutted. It is fallacious and allowing it to go unchallenged has done a lot of damage to the reputation of the USS.

The argument is that equities – that is stocks and shares of companies – are inherently volatile in that their prices vary a lot over time. So a prudent pension scheme should not rely on this type of unreliable asset class too much. USS has traditionally invested in equities and has too many in its portfolio.

This argument is wrong. A pension scheme like the USS covers a whole industry – a public service actually, higher education – so it has a long time horizon. It is not like a pension scheme for a company that might have a finite life cycle and then go out of business. In that case it makes some sense to get out of risky equities as the members approach retirement because there needs to be a secure income to pay the pensions.

But actually for an infinitely lived scheme the risk in equities can be removed by holding a diversified portfolio. Investing in a wide range of company shares across the whole economy enables the scheme to get a good return on investment long term while avoiding risk through both diversification and intertemporal smoothing. That is what is described in the USS “Statement of Investment Principles”. (It is known as the equity premium.)

The USS has to invest its surplus of over £1 billion per year. Where should it invest if it is to get the highest return? Increasingly it is investing in alternatives which includes infrastructure. It recently bought a large chunk of Heathrow, NATS, Sydney airport, etc. These investments share many of the characteristics of equities – they give a good long-term return that matches the long-term nature of the liabilities.

What is de-risking?

It sounds like something we should all want – getting rid of risk is like being against sin – but it is actually a technical term used in the pensions industry. Many DB pension schemes are closed to new members or future accrual. Most of their income comes from investments. As the members approach retirement and retire the need is for the income to become more secure. The investments are moved from risky but rewarding assets like equities to safe assets like government bonds (gilts).

The trouble is that the same logic is being applied to the USS – it is being treated as if it is to close. So holding a diversified portfolio will cease to make sense. If assets are moved to the lower earning gilts then the income lost has to be found. Hence the cost of doing that is being added to the deficit. That has to be paid in increased contributions or reduced benefits.

Why is this logic being applied? It is not necessary that the USS be regarded in this way. It is an infinitely long-lived scheme. The only thing that will lead it to fail is if members do not join it – and making them pay for de-risking is one way of ensuring that happens.

A policy of de-risking is not reducing risk at all. In fact it is increasing the risk. The employers are not saying that they want to address a deficit of 'only' £8billion. They are saying that the deficit is unsustainable because it is going up to £13billion as a result of derisking!

According to their latest briefing the UCU negotiators seem to be ambivalent about de-risking. They should reject it entirely on principle. We should defend the USS as a sector-wide pension scheme with an infinite lifetime continuing into the indefinite future.

What does the law require?

The regulations are laid down in general terms in the Pensions Act 2004. Pension schemes must be valued every three years. How this is done and the procedure when there is a deficit are described in the code of practice in the associated order in council, here.

But the most problematic clause is 128 which rules out smoothing on the grounds it is inconsistent with the strict market prices. This means that a very strict theory of market prices is taking precedence – market fundamentalism. It is based on the belief that markets are perfect and effiicient.

So what is the nature of the crisis?

The legislation gives wide discretion to the trustees and the regulator. The regulator is concerned primarily with protecting the pension protection fund from any claims on it. The regulator does not have to give priority to providing a good pension scheme for members.

The trustees ought to be taking a view. In the case of USS it is usually thought of as long lived (an immature scheme). So the deficit does not matter - it is cyclical and will disappear as soon as interest rates on gilts increase.

But they are not thinking in these terms any more. They are in Willetts' world of competition between universities that are treated not as public bodies but private companies operating in the market place and competing with new entrants. There is no difference essentially between, say, Oxford and BPP university. If a university fails to attract enough students it will be allowed to go broke. So from this point of view prudence requires a need to have its pension promises funded at all times. That is its share of the USS. Hence the deficit begins to matter enormously. So although the sector as a whole is presumably not going to go bust each individual institution can do so. This new thinking - privatisation - is what lies behind the employers thinking.

That is why they want to introduce de-risking. Nothing to do with equities not being a good investment. Equities are the best investment for a long-term pension scheme like USS if it is seen as covering the whole sector. They have a higher return and the risk can be borne because it does not matter in the short term - the pension scheme does not need to draw on its assets in the short term.

- 7 comments by 2 or more people Not publicly viewable

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  1. Asterion

    Excellent article. Thank you for explaining clearly all the issues that are normally obfuscated by the so-called financial experts.
    It makes one despair that we are living in a once great country with a once great higher education system that are both being brought to their knees by small-minded political dogma and fundamentalist free-market theories.

    07 Nov 2014, 13:33

  2. Bob

    Please could you explain this assertion?
    “Thus we must assume that pay continues to rise faster than inflation”

    It seems contrary to the pessimistic assumptions in the previous sentences.

    07 Nov 2014, 23:00

  3. Dennis Leech

    It tends to exaggerate the liabilities.

    08 Nov 2014, 14:25

  4. Dennis Leech

    @martin_oneill @Dennis_Leech @ucu as a former broker to USS I can say without compunction that it is one of the best fund managers I know— Dan Davies (@dsquareddigest) November 6, 2014

    08 Nov 2014, 15:11

  5. Colin Elliot

    What I am really curious to know is what have comparable schemes done in the light of similar scales of ‘deficit’. Is there whole-sale ‘de-risking going on? Or is this more of a unique strategy: it is interesting to note the new CEO comes from a The Pensions Regulator (tPR).

    12 Nov 2014, 23:18

  6. Dennis Leech


    It depends what you mean by comparable schemes. Technically it is a private company pension scheme run by multiple employers. But it is also a pension scheme for a large sector of higher education which is a nationally important public service, just as much as the rest of education (schools, FE and post-92 HE).

    Private company schemes have been closing to new members and also many of them to new accrual for some years. ‘De-risking’ – in various ways – is a central part of their strategies. So it is happening in private pensions. Arguably there is justification for it because private companies can go bust and be unable to honour their pensions promises if there is a deficit.

    But the university sector is not like that. The Teachers’ Pension Scheme is not going through this kind of process. It is not in ‘deficit’ and is not ‘de-risking’ because it is a pay-as-you-go scheme guaranteed by the taxpayer. The pre-92 university sector should equally be seen a permanent part of the public sector.

    Unfortunately many pensions experts see the USS as a private scheme, forgetting what universities are, and when they talk about other schemes in the industry they mean private schemes.

    The chief executive of USS was the chief executive of the pension regulator before joining USS so must have had some responsibility for forcing on us the last lot of rule changes.

    13 Nov 2014, 10:14

  7. Tim White

    Thanks for this. I confess I read with alarm the summary of USS investment in Private Eye and could only conclude that USS was poorly managed and this goes someway to countering that perspective. However, can I ask, from a position of economic ignorance, does the change in pensions that allows taking lump sums rather than purchasing annuities make the fund more susceptible to sudden shocks rather than steady draw-downs? And second, does an eradication of the deficit then allow the fund to be dissolved, paying up on its liabilities (obviously much diminished) and turfing out existing members to take their chances in the marketplace?

    13 Nov 2014, 11:16

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