First Actuarial’s response to USS’s self-sufficiency-in-gilts approach

The UK Universities Superannuation Scheme (USS) has recently released its ‘Proposed Approach to the Methodology for the 2017 Actuarial Valuation’. The Universities and Colleges Union (UCU) have commissioned First Actuarial, a consultancy held in high regard by pensions professionals, to provide an analysis. Two of their actuaries, Hilary Salt and Derek Benstead, have now written a report for UCU.

Their report challenges the role and nature of USS’s self-sufficiency valuation, which assumes investment primarily in gilts (government bonds), and argues for the superiority of a self-sufficiency valuation that assumes investment primarily in equity (stocks and shares).

‘Self-sufficiency’ plays a crucial role for the following reason. According to analysis USS commissioned for the last valuation, employers could afford to increase their contributions by 7% from the current 18% of salaries to 25% of salaries if necessary, but no higher. Beyond such an increase in employer contributions, pensions obligations would need to be paid almost entirely out of assets in the scheme. In other words, the scheme would have to become ‘self-sufficient’ beyond this point. This is USS’s rationale for their self-imposed ‘Test 1’, which is satisfied only if it is possible to make the pension scheme self-sufficient without exceeding a 7% increase in the employer contribution rate.

What level of assets, and of what kind, are required for self-sufficiency? This is what USS says:

[a] The ‘self-sufficiency’ measure of the liability reflects the required level of assets to meet all future benefit payments to a very high probability without the need for additional contributions. [b] It corresponds to a discount rate very close to gilts (i.e. very close to the yield on an appropriate portfolio of UK government bonds). The discount rate used by the trustee for the self-sufficiency liability is gilts + 0.5%. (‘Proposed Approach’, p. 10, n. 5, my bold lettering added)

When self-sufficiency understood as gilts + 0.5%, Test 1 forces USS to de-risk its assets out of higher return equity and into lower-return bonds. It is forced to do so in order to ensure that a 7% increase in the employer contribution rate is enough to finance the transformation of their actual mixture of higher-return assets into a self-sufficiency portfolio heavily invested in gilts which nevertheless generates the same amount of income.

Although Salt and Benstead don’t describe it as such, I think it helpful to understand First Actuarial’s response as involving the acceptance of [a] while denying [b]. In other words, First Actuarial denies that USS would need to be invested primarily in gilts in order to almost guarantee that it can meet pensions obligations out of nothing other than employer contributions that increase by no more than 7% plus investment income.

First Actuarial’s argument is that, given everything we now know about long term returns on equity versus gilts, it would be far less expensive to invest nearly everything in equity rather than gilts in order to achieve self-sufficiency as defined by [a].

They draw on historical data to make their case. They take the return on equity for every period between 1920 and 2015, understood as the return from 1920 to 2015, from 1921 to 2015, from 1922 to 2015, etc. The level that is sufficient to nearly guarantee full payment is that which would have fully covered pensions obligations, even during the worst performing of these historical time intervals.

This argument is captured in the following graph on p. 15 of First Actuarial’s response.

If First Actuarial is right, USS is mistaken in assuming that, pound for pound, investment in gilts provides a more effective means than investment in equity of meeting pensions promises almost for certain. Therefore, Test 1, which is driving a costly de-risking of the assets of the pension scheme out of equity and into gilts, rests on a mistake.

(Click this link for a follow-up to this post, in which I question the rationale for Test 1’s focus on a 7% increase in contributions.)