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September 17, 2012

Universities' Pensions Deficit is not Believable

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We have been told that there has been an increase in the deficit in the USS pension scheme in the past year that is so large as to threaten its very survival. (See the Times Higher Education report “Deficit puts pension scheme in jeopardy”, 13th September 2012.)

The funding level has suddenly plummeted from 92 percent to 77 percent between March 2011 and March 2012, but we have been given no explanation as to what is so wrong about it that would cause it to collapse on such a scale, which is far in excess of what would be caused by problems that critics (eg Tom Pike and Jim Naismith) have pointed to.

I think some analysis is needed before we believe some of the alarmist statements being made. There are grounds for believing there is a lot of artificiality in the figures and that they do not reflect fair value accounting.

The deficit is the difference between assets (USS investments) and liabilities (future and present pensions). Assets have INCREASED by 1.5 billion pounds. So the explanation cannot lie in poor investment performance. The problem is with the liabilities that have ballooned by £8.4 billion pounds - IN ONLY ONE YEAR. How is such a change – not only large but astronomical - credible? That is the question we all need to address.

It is all the more astonishing since the rule changes that were introduced last October ought to have reduced the liabilities, not increased them: introduction of the CARE section, increasing normal pension age to 65, flexible retirement, capping inflation adjustment. It cannot be due to increasing longevity since there has not been a major change in predictions of life expectancy.

(Increasing life expectancy is often blamed for deficits but its effect is exaggerated as the last valuation report showed: it increased the deficit between 2008 and 2011 by 0.6 billion pounds - much less than several other items such as the impact of basing inflation indexing on CPI instead of RPI which reduced the deficit by 2.9 billion pounds. The longevity argument is really a con. If members are expected to live one year longer, the liabilities figure increases by 0.6 billion pounds - significant but not an existential threat to the fund.)

WHY, then, has the reported liabilities figure gone up so much in one year? The answer is that the figure is artificial and highly misleading due to the way it is calculated under legislative rules, introduced in the Pensions Act 2004, that now apply to all private sector defined benefit pension schemes (of which USS counts as one). The reasons are technical (but no less controversial for that): it is calculated as a present value capital sum using a discount rate based on gilt rates which are currently very low, hence the large figure.

BUT the ACTUAL liabilities – the monthly payments to USS pensioners and future pensioners - are no different than they were before! So why the change in the liabilities figure? In fact the funding deficit is an artifact, a result of the overcautious regulatory regime brought in by the last government, that was meant to protect private pensions against the insolvency of the corporate sponsor but is having the unintended consequence of forcing perfectly good schemes to close.

It is worth reminding ourselves how a private pension scheme works: a group of employers and workers pay contributions into a collective fund, out of which pensions are paid to retired workers under defined rules, and surplus funds invested to earn dividends and interest for the future. It should be judged simply on whether its income exceeds expenditure on a sustainable basis, taking account of all future foreseeable changes.

From this point of view the USS is not in bad shape. The latest published accounts (2011) show that annual investment returns (including dividends from our investments in highly profitable companies like Shell, HSBC, Vodafone, BP, etc and government bonds) were about £2.4 billion, easily paying the current pensions bill of £1.4 billion per year. On top of that rising contribution income from members and employers brought in another £1.5 billion per year.

This is not the whole story, of course, because the scheme is still growing and it is necessary to make allowance for expected future changes: such as rising life expectancy, expected salary increases, retirement ages, inflation and so on. How this is done is an important issue surrounded by much uncertainty.

But the one thing that is certain is that interest rates on government bonds have nothing to do with it (except to the extent that part of the investment portfolio is in government bonds). What a member receives in pension payments when he or she retires will depend on their years of service, their pensionable salary, inflation and how long they live. The interest rate on gilts does not have any effect on this, so it is really bogus to convert these payments to a liability figure using it.

The same artificial calculation has led to yawning deficits in many company pension schemes. In August the ONS reported the combined UK deficit on this basis was £280 billion which has led to calls for emergency extra funding from employers. The artificiality of all this has led bodies such as the Confederation of British Industry and National Association of Pension Funds to call for government action to change the rules.

The whole emerging fiasco in funded pension schemes like USS is the result of the overeager application of neo-liberal economic thinking during the boom years. What is happening to USS, and the other final salary pension schemes in the private sector, is the logical culmination of a process based on the philosophy that “there is no such thing as society, only individuals and their families”.

What is needed is not to close down the scheme, but to defend it for the success it is, and for the government to look again at the distortionary regulatory rules that have been introduced without sufficient thought.

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