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May 20, 2015
The pensions regulations place a paramount responsibility on trustees to try and secure the best returns for the members. This has been used as an argument against those who argue that pension funds should not invest in unethical activities such as armaments manufacture, fossil fuels, racism and apartheid, tobacco, and so on. Campaigners have always been told that the only thing that really matters for the trustees is their fiduciary duty and to bring in ethical considerations will go against that.
The same logic ought to govern the overall approach to managing the scheme and not just to the choice of which companies to invest in (assuming the argument is true which I do not - the Church of England investment fund does very well despite having a strong ethical basis). Yet the USS trustee is following a strategy that is not demonstrably in the interests of members just as if it were choosing certain investments for non-financial reasons. If, for example, it decided to divest from cigarette manufacturers, that could well result in lower returns to the fund if the cigarette shares did well. On the other hand, it could make no difference or even benefit the fund if the shares did badly. There is no certainty but the pension fund trustee makes a decision based on what he or she believes.
There is an analogous situation in relation to the whole management strategy at the USS where the trustee is following financial models which have been shown to be wrong rather than their fiduciary responsibility. Whether following the financial models that currently dominate the thinking of the current USS leadership will deliver better returns than pragmatically taking a view about the future or not is a matter of uncertainty. But there surely must be a basis for a legal challenge to a trustee who bases his or her strategy dogmatically on models that have been shown by academic economists and mathematicians to be flawed.
One example is the idea that risk can not only be measured but also managed. That is a very dangerous idea whose consequences we saw during the banking collapse of 2008 when such measured failed. Measures of risk proved to be chimera: of use only when there was little risk but to be unreliable when they were really needed.
Another example is the belief that it is possible to borrow and lend indefinite amounts at the so-called risk-free rate of interest. That might be a reasonable assumption for a small pension scheme worth a few million pounds but is very misleading for a massive scheme as big as the USS, not only the largest pensions scheme in the country but also big enough that its behaviour affects market prices and to have macro-economic effects.
The idea that the returns on an investment can be expressed in terms of its mean and variance, and that the variance measures risk, is not true as a general statement. This is true in the special case where the returns have a so-called Normal (Gaussian) distribution but the statement is not true in general. And it has been demonstrated (by the mathematician Benoit Mandelbrot and others - see Mandelbrot and Hudson, further references to follow) that returns are not normally distributed so it is imprudent, not to say dangerous, to use the model when making real decisions affecting peoples lives. (An excellent critique of financial economics more widely and its role in the 2008 crisis, see Yves Smith, Econned.)
This prompts the question: why, then, do some pensions professionals continue to use models that are flawed and could be dangerous; is that not imprudent? It is a good question to which there is no satisfactory answer. The most likely reason is that the normal distribution is mathematically rigorous and analytically tractable and therefore convenient to use. Results based on it can be described as scientific, objective and so on, and also modern, so there can be an idea of progress. The use of the model has been described as rather like a drunk who has lost his keys in the street and looks for them under the lamp post because that is where the light is.
But that is precisely what the USS trustee is doing. They like to follow the model because it enables them to assume a direct link between risk and mean return. This is the thinking behind their so-called `de-risking proposal' that members are being asked to agree to. Their proposal is that the USS investment strategy is changed (slowly over years) to a lower risk/ lower return portfolio with members agreeing to compensate for the lower return with reduced benefits and higher contributions. But there is no evidence that this will make it more likely that the trustee will be able to pay the pensions promises when they come due. There are compelling arguments that the best strategy could well be to invest to maximise the long-run return. Some actuaries argue against the de-risking idea on precisely these grounds.
There are other examples of the introduction of flawed financial models by the USS trustee which can be challenged. There is an idea among some that assets are only to be considered as random variables following a random walk process. (Again usually based on the application of the normal distribution to ensure analytical tractability.) But investments in real productive assets such as company shares are governed by the real economy. Yet we are told that investing in real productive assets is too risky. Yet long-term we know that there is a substantial so-called equity premium by which shares outperform bonds. A long term investor like a pension fund should be allowed to invest long term since its liabilities are long term. And investment in equities can be seen as contributing to future economic growth if it leads to capital formation.
There is a belief in the idea that markets provide information better than any individual person can. This economic idea, related to the so-called 'efficient markets hypothesis', has been shown to be a fallacy by leading economists (eg Grossman and Stiglitz, American Economic Review, 1980 and others) yet this - what should be authoritative evidence - is ignored by pensions professionals such as the current USS management. Thus, for example, the only way to forecast inflation in the distant future (vital for calculating the pension liabilities) is to look to the market and study the differences between index-linked gilts and others. We are told that such estimates are 'objective'.
And so on. The use of financial models which are flawed in either statistical theory or economics seems to be widespread (though thankfully not universal) in the administration of pension schemes, of which the USS is becoming a leading culprit.
Yet the USS is the pension scheme for the universities. Its members include experts who understand the reasoning and the evidence behind the pensions theory and financial models. We can therefore challenge flawed thinking. We should not accept the suggestion, made, I believe, by someone close the negotiations that such thinking is 'economic orthodoxy'.
I am not a lawyer but I believe there are grounds for at least considering a legal challenge to the trustee on grounds relating to fiduciary responsibility. There is a motion to the forthcoming UCU Congress from the Lancaster University branch calling for such a legal challenge. It is to be hoped that it gets passed and the union takes the necessary action.
May 19, 2015
Just before the election David Cameron announced that the well known independent pensions expert, who was previously the government's Older Worker's Champion, was to be made a Conservative peer. Now she has been appointed pensions minister in succession to the LibDem Steve Webb who had done the job for the whole of the last parliament. Both are experts in their field but they have very different perspectives.
As far as the main question facing the USS, the measurement and management of DB pension fund deficits, is concerned there is a big difference between them. Steve Webb - as was to be expected from one of the Orange Book Liberals for whom free markets are fundamental - was a consistent believer that the deficits computed using market-based ideas are real, and frequently said so. Ros Altmann on the other hand, has been more pragmatic and much less of an economic ideologue. She has, for example, explicitly criticised the USS deficit in an article in the Financial Times, "Scare stories about USS liabilities are overblown".
The article make a number of important points that economic neoliberals like Webb assume away in their belief that the world consists of perfect markets everywhere. For example she says "A fund the size of USS cannot fully de-risk", "Pension funding has become more challenging in a post-quantitative-easing world, where investment risk and mark-to-market pension liabilities have been distorted by Bank of England gilt purchases. This requires a measured, long-term response to pension funding, which can look through shorter-term distortions and readjust over time where necessary. Indeed, switching to bonds at current rates may itself be a `massive bet'.", "Further changes may be required to ensure intergenerational fairness to cohorts of sponsors and members with such a large, open scheme, but this should be negotiated on the basis of long-term forecasts rather than knee-jerk reactions to short-term market factors."
Her appointment probably has little direct relevance to the USS crisis. But it is possible it might lead to a change in thinking about the pensions regulatory system more widely.
May 03, 2015
This article, "Why are error margins ignored in LDI?", in the latest edition of IPE Investment and Pensions Europe, should be required reading for anybody involved in - or with an interest in - occupational pension schemes. It argues that, in order to be of practical use in guiding decisions, valuations of assets and liabilities should be estimated with a margin of error. This point - that is good science but actually little more than common sense - is directly relevant to the current debate about the universities pensions scheme, the USS, whose trustees seem to be ignoring it completely.
The article says that pension schemes rely too much on financial mathematics for valuations, with its precision leading to a false sense of certainty, and fail to learn the lesson from experimental physics: that margins of error in measurements are just as important as the measurements themselves. We could also say that it is a problem in economic thinking due to too much reliance being placed on the idea that competitive markets are in equilibrium - leading to a belief in precise valuations taken as having the status of fact. Such thinking forgets that in the real world there is everywhere statistical error, which is often a very wide margin. An approximate figure with a wide margin of error is often a more accurate description of reality than one presented with spurious precision.
The article begs the question: why is this issue not being actively discussed by everybody involved in running pension schemes, actuaries, accountants, trustees - and the regulator and the government?
March 30, 2015
"When I use a word,” Humpty Dumpty said in rather a scornful tone, “it means just what I choose it to mean— neither more nor less.” Lewis Caroll
"Words are a wise man's counters, they do but reckon by them; but they are the money of fools." Thomas Hobbes
The UUK consultation document Funding background from the trustee is highly misleading to say the least. It contains statements that appear superficially to have a straightforward meaning in ordinary language but are in fact technical in that they require special assumptions for them to be true. Also some statements are downright false. It also has to be said that the trustee's approach to funding raises the question as to whether the trustee is fulfilling its fiduciary duty to always act in the best interests of members. Here are some of my comments.
Valuation and Funding Methodology
The document says:
Since 2011, the deficit has increased significantly and, based on the current benefit structure (ie without taking any account of the proposed changes), the trustee anticipated that it would report a deficit of approximately £12 billion for the March 2014
There has not actually been a valuation as yet, by the way. That cannot be done until the changes to the scheme have been agreed. So there is an important element of circular reasoning here, which is rather awkward: the £12 billion deficit depends on members (via the trustee) agreeing to it.
Importantly there is selective use of evidence: the £12 billion figure assumes some changes are implemented but not others. It assumes valuing the liabilities using 'gilts plus' rather than 'best estimate minus' (discussed at length in the First Actuarial report); also 'de-risking': switching from long-term growth investments to lower-return (but less volatile) government bonds. At the same time benefits are assumed unchanged. Both sets of assumptions point in one direction making the deficit bigger and bigger. This is highly tendentious and quite biased reasoning.
Then it says:
... the most significant factor is the change to the assumption which the trustee is making for future investment returns – and the effect of a lower assumption reflecting the changed economic environment – which has added around £7.6 billion to the amount needed to pay pensions."
This does not mean what it appears to say if it is read as ordinary English. The reader might think it alludes to the financial crisis from 2008 on. But investments have recovered since then and the USS investment managers have done well. No. What the trustee means here is how the future pensions promises are valued - a highly technical matter. The USS has to find a figure to stand for a theoretical sum of money in today's terms that would be enough to pay them (assuming it lent securely to the government at low interest rates). Government interest rates - gilts - are not investment returns determined by the market but fixed by the government for reasons of macro economic policy. The term 'future investment returns' has to be understood in this very specific technical sense and is not referring to actual future investment returns that will be earned on the fund's investment portfolio.
This is the nub of the issue. The USS has a large and volatile deficit due to this valuation of liabilities - not poor investment returns. The USS trustee is using extremely low gilt rates for this calculation and not actual investment returns and calling this "the assumption ... for future investment returns".
... it expects those overall returns will be lower given the challenging future economic environment. These assumptions are ultimately judgements which all trustees must make about future anticipated investment returns. These assumptions are reflected in the valuations of scheme liabilities, and in the increased deficits of many defined benefit pension schemes."
What it means by "challenging future economic environment" is that it believes gilt rates will remain low for the indefinite future. The trustee is basing its policy on a myth that currently very low interest rates reflect the "economic environment" notwithstanding that it is being deliberately manipulated by the Bank of England as a matter of policy ("quantitative easing").
The pensions promises that need to be paid have little to do with this "economic environment". Pensions that are to be paid in the future are the same whether interest rates go up or down although they change the valuation of the liabilities a lot. That is why the valuation is inherently so volatile (hence not very meaningful).
The main reason the deficit is so large is that the liabilities valuation increases every time interest rates go down. If interest rates go low enough (and some inflation-adjusted gilt rates are already virtually zero and some actually negative) the liabilities will become infinite. The valuation methodology is fundamentally flawed because it actually breaks down when the discount rate is zero. It is mathematically equivalent to trying to divide by zero.
The document contains a misleading statement about the pressures due to rising longevity:
Another factor contributing to this increase is the projected improvements to members' life expectancy. The trustee has reported that the changes to the projected life expectancy assumptions between 2011 and 2014 have added almost £1 billion to the amount needed to pay the pensions promised."
This statement appears to imply that there is factual evidence that life expectancy is increasing faster than before. In fact the evidence from the Office of National Statistics tells us that this is not so. But the trustee has decided to increase it nevertheless on the grounds that a survey of other pension schemes conducted by the pension regulator has shown that a majority are assuming a higher rate of improvement in longevity than is evidentially indicated.
So the approach of the USS trustee is to follow the herd. After all, whatever might happen to the USS, nobody could reasonably blame the trustee. They are only following John Maynard Keynes' dictum: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
The de-risking plan versus an ongoing pension scheme: planning to fail?
The document then goes on to say:
Additionally the trustee has carried out some work to update its understanding of the potential financial strength of the sector ... concluded that the scheme's reliance on the sector is considerable and should not grow over time.
The trustee has therefore proposed ... to gradually reduce the amount of investment risk in the scheme - over a 20-year period - in order to maintain the overall levels of risk, therefore reliance, on the sponsoring employers."
This is extraordinary. It means shifting investments from return-generating equities (ie financing investment in real productive capacity by companies thereby helping economic growth) into lending to the government by buying bonds. This is estimated to increase the deficit by £4.4 billion (part of the £12 mentioned above) which is the value of investment income foregone. This decision is to increase the deficit deliberately as a matter of policy and its wisdom is highly debatable to say the least.
The fundamental, overarching risk facing any pension scheme is that there will not be enough money to pay the pensions when they fall due. This new 'de-risking' policy does not necessarily reduce the risk of that happening. Indeed it seems if anything it might increase it. By giving up £4.4 billion of investment wealth it could be seen as almost planning to fail.
The trustee is focussing only on investment risk and ignoring investment return. Yet both are equally important to addressing the fundamental hazard of running out of money. The two need to be looked at together. It could well be that increasing investment in equities and long-term return-bearing assets will improve the chances of the scheme meeting its promises. Many actuaries argue against this kind of de-risking on precisely these grounds. (For example.)
There is also the fact that - as a general principle - this approach is harmful to the economy by leading to resources being diverted out of productive investment.
Is the trustee acting in the fiduciary interest of members?
This policy by the USS trustee is not evidence-based. The thinking behind it seems to be untested financial theory intended to be applied to private companies rather than universities.
Given that they are so controversial it is highly questionable whether these decisions are in the best interests of the scheme. It is certainly not the case that there is solid evidence behind them. The question therefore arises as to whether the trustee is genuinely fulfilling its legally required fiduciary duty. Has the UCU, as the representative of members, considered this? As far as I can see there has been no discussion of the possibiity of a legal challenge on these grounds.
Are universites acting in their own best interests as universities?
The policy seems to be based on the idea that the employer covenant with the universities only has a limited period. This seems an extraordinary idea for pre-92 universities with established reputations, a unique role in society and no reason to think they should not continue. Presumably as with so much else in this dispute it derives from the new idea that universities are businesses just like any other in the private sector and therefore must copy as many of their management modalities as possible. The recent introduction of rigorous line management, with targets defined as metrics, firing academics if they faill to meet short term targets, paying vice chancellors CEO salaries, and so on, are all evidence of the zeal with which universities are embracing what they image to be how businesses behave. Applying the same logic to pensions is more of the same. This is a grave mistake because universites by their very nature are public institutions.
One wonders if the university managements have really thought deeply enough about where they are going before responding to the surveys conducted by the USS and UUK.
March 17, 2015
The USS dispute is primarily an intellectual issue. During the consultation period - when members can have their say about its future - it needs to be addressed as such by the university community.
We know that the scheme is very profitable. It currently makes an annual surplus of over £1 billion after paying the pensions of retired members. There are good grounds for believing that it will probably remain in surplus for at least 20 years. See the First Actuarial report that was commissioned by the UCU. Unfortunately the USS trustees have not carried out this analysis (or if they have they are keeping it secret) and have yet to answer the questions that First Actuarial put to them which would enable us to see the true situation.
Instead they tell us there is a deficit that is not only large but getting bigger (and increasingly volatile). But the methodology they use is highly questionable, being based on untested economic beliefs from the neoliberal faith. It assumes it is possible to assess the health of a pension scheme solely by looking at the market value of its assets (its investments) and estimated liabilities (an imputed figure to represent the pensions already promised) at a moment in time, without needing to worry about the cash flows that are actually needed to pay the pensions promises.
A lot of assumptions are required for this methodology, many of them highly debatable - they are held as articles of faith by the practitioners. The main idea is that 'the market' knows more than any human ever can: specifically it can forecast the future - ergo there is no need for actuaries to bother trying to model the future income and pensions: asset prices contain all information about future investment returns and after some more assumptions are swallowed a valuation for liabilities is calculated as well. These figures are presented without any estimates of error and the difference is called 'the deficit'.
Although these criticisms have been made by academic experts, economists, statisticians, financial mathematicians, actuarial scientists, philosophers and others (both as individual academics and through their institutions, notably LSE, Warwick and Imperial) as well as UCU negotiators, the UUK and the USS trustees will not discuss them. They behave as if their approach is a kind of orthodoxy to which there can be no alternative and refuse to engage in open intellectual debate. They present their opinion as objective fact.
So they have told us that the deficit as of March 2014 is estimated at over £12 billion, but has increased to £20 billion by January 2015 due to unspecified 'market conditions'. In the past, before this mark-to-market methodology was adopted, actuaries used to calculate pension scheme variations over periods of decades reflecting demographic and economic trends. If there was a funding problem it would show up over many years and could be dealt with soberly and responsibly. Yet here we have a massive two-thirds increase in the deficit in a matter of a few months. That should surely show us all that the method is not fit for purpose.
The methodology: requiring all pension schemes to be funded, in the technical sense of assets being always at least equal to liabilities, in order to protect the pension protection fund - was actually made law by the Pensions Act 2005 and associated regulations. Like much Blair-era legislaton it has had dire unforeseen consequences that has led to many workers in the private sector losing their pensions as schemes have closed.
The problem is that the liabilities calculation is not reliable. When government bond rates (gilts) go lower - as they are now under the government's so called quantitative-easing policy the liabilities figure becomes larger and more unstable. That is what is happening - but it has little if anything to do with the actual future pension requirements. Some gilt rates are even so low they are below inflation, hence negative in real terms: when that happens the method would seem to fail.
The fact that so many university managements are unthinkingly following the USS management and going along with this is a real intellectual failure on the part of British universities. They are not doing their job of independent enquiry leading to their taking a view of the true situation - and moreover on a matter that applies to their own material interests where they should have a strong incentive to get it right. It is not the role of universities to simply follow convention, even if some of the negotiators have claimed it to be 'economic orthodoxy'.
The trustees' role is to ensure there will be enough funds to meet the pension payments when they fall due. They means - fundamentally - looking at income and expenditure going forward into the long distant future. That means taking a broad overview - and not relying on the belief that the market provides superior information.
February 12, 2015
What is alarming about the deal that has just been agreed between the UUK and the UCU negotiators is the doublethink it requires of anyone who believes it offers a solution. It is intended to reduce risk – by making so called technical assumptions on the most prudent basis possible so as to avoid the risk of the money running out for whatever reason. Yet the resulting figure for the so-called deficit that this gives is extremely volatile.
Thus for example we have been told that the deficit was around £12 billion in March but had increased to an estimated £20 billion by December. Normally pensions accounting is very boring with changes taking place gradually over many decades. Yet here we are expected to believe that the deficit has varied by two thirds in only nine months! And no reason is given except vague market conditions. (And we have not had a stock market crash.)
Why did nobody say to the chief executive and the trustees: “Steady on – this can’t be right. There must be something wrong with your model. You have supposedly eliminated risk by using your new methodology, very prudential assumptions and all, yet there appears to be an awful lot more risk/volatility than there was ever before.”
The problem is of course caused by the fact that the methodology is based on purely theoretical financial models with no empirical evidence behind them. In other words blind faith.
The deal does nothing to solve a funding problem but instead makes it worse. The same theories that contributed to the banking crisis in 2007/8 are at work here. We have learned nothing from that experience. And we are told this is ‘economic orthodoxy’ so cannot question it.
October 28, 2014
The Assembly meeting was well attended.
The motion was carried:
Votes for 187
Votes against 0
Total votes cast 201
The university has agreed to hold an Assembly meeting (of the whole academic and related staff) to debate the following motion passed by the UCU at its last branch meeting. The Assembly is taking place today and will receive presentations of the university position and the UCU position presented by Jimmy Donaghey (national negotiator as well as Warwick member of staff) as well as debating the motion.
Requests the University of Warwick Senate and Council to:
- declare a clear belief in the importance of a good defined benefit pension scheme that provides a secure and predictable income to staff in retirement as an essential element of a world class university;
- note that the latest Annual Report and Accounts of the USS pension scheme (March 2014) indicates an operating surplus of over £1 billion for the year;
- also note that the fund has seen surpluses in 2013, 2012, 2011, 2010, 2009, 2008, 2007, 2006, 2005, 2004 etc. (USS Accounts: http://bit.ly/ongoingsurplus);
- recognise that the scheme is 'immature' (continues to have more money going in than out and membership is still growing) and clearly not in need of a de-risking strategy;
- acknowledge that the reported 'deficit' of the scheme is predicated on the assumption that a recovery fund must be calculated to pay all future pensions if all USS-scheme universities cease to operate simultaneously (Q7, EPF Q&A, http://bit.ly/whatdeficit);
- declare it does not believe this is a credible scenario for the basis of a recovery plan, because it takes prudence to ridiculous extremes;
- use its role in UUK and the Employers’ Pension Forum to bring influence to pull back from the proposals that will change USS beyond recognition, and;
- acknowledging that this is a regulatory requirement under current arrangements, explore mechanisms for lobbying for regulatory change.
October 06, 2014
One of the chief reasons given by university employers for the changes to USS that they want is that we are all living longer in retirement, life expectancy has increased.
But my colleague Jane Hutton, professor of statistics at Warwick university, has shown that they have been overstating their case and posted false figures on their website.
The Employers Pensions Forum (EPF) Q&A webpage originally stated (Q9): "Current longevity patterns are significantly different to those when the scheme was set up in 1974. Then it was expected that a USS pensioner retiring at age 65 would live for 6 to 8 years in retirement so the cost of the scheme and the contribution rates were set on this basis. By 2014 the anticipated length of retirement is around 30 years, ..."
In other words, in 1974, 'our' life expectancy was half (49%) that of the general public, but by 2014 it had risen to 1.4 to 1.6 times greater! The Office of National Statistics has an increase of 1.3 to 2.3 years for each decade; the EPF has an increase of 5.8 years for each decade.
Jane wrote to the EPF pointing out that these figures are hardly credible since they would require us to believe not only that life expectancy was grossly underestimated when USS was set up in 1974 but also that rapidly increasing life expectancy had been ignored subsequently.
She did not receive so much as an acknowledgment of her email. But when a colleague looked at the same webpage he could not find the numbers because they were no longer there. Fortunately, Jane had printed the original version of the webpage as it had been (see Q9). The new page with the offending figures for life expectancy removed is here, but with no indication it has been edited and the same date as before.
September 23, 2014
The current edition of Private Eye contains a highly misleading report about the universities' USS pension scheme (Gray-vy train, Eye no. 1375, 19 September-2 October 2014).
The report draws attention to the salary of the fund's chief investment officer, Roger Gray (up last year to £900k from the previous year's £600k) and suggests it is unjustified given the reported funding deficit leading to probable cuts in benefits to members.
It says:"While academic eyebrows will be raised over a pay packet more than 20 times as much as many of theirs, they might also question those running the scheme and responsible for the dubious investment policy."
This is actually a load of tripe (as the Eye might say). Last year the scheme's investment portfolio earned a respectable 7.6% return. (uss_warns_of_substantial_deficit_as_fund_returns_76_news_ipe.pdf.) It is the opposite of the truth to call that a dubious investment policy. Too often investors' bonuses are unrelated to performance but in this case Mr Gray's increase is actually based on good performance.
The article repeats criticisms of the USS investment policy that are familiar to anyone who has been following the debate. The deficit is actually a result of a controversial accounting methodology that treats the scheme as if it is one for employees of a small private company rather than the whole pre-92 Higher Education sector.
If the USS is regarded in the same way as other public sector schemes such as the Teachers Pension Scheme, on a pay-as-you-go basis, measuring its health in terms of its income and expenditure, it is actually in good shape: its income from its investment portfolio was over £1billion according to last year's accounts and with increasing membership.
Whether or not its investment strategy is wrong depends on which of these two views is taken. If it is a scheme for an important part of the UK education sector it wll have a very long (or indefinite) time horizon and will best be invested in equities to get the higher return over the long term. But if universities are seen as firms operating in the market place - and could go bust at any moment - then equities are too risky.
It is not clear that USS's investment strategy is wrong.