Why should it matter that we can’t afford to do what we have no reason to do?
A revised critique of USS on short-term risk and reliance
USS maintains that the level of “short-term risk” to the scheme is a matter of how much it would now cost to exchange the current growth portfolio of assets for a lower-risk, lower-return ‘self-sufficiency’ portfolio weighted towards gilts and other bonds (see pp. 10–11 on the “short term risk portfolio” and pp. 26–30 on “risk and reliance”).
When, as now, the gilt yield is so low, it would be prohibitively expensive to exchange the scheme’s growth portfolio for a self-sufficiency portfolio that generates the same absolute level of investment returns. The cost of such a shift has fluctuated between £18 bn and £27 bn in recent months (p. 29).
USS nevertheless insists that “the trustee needs to be sure that the relative security of moving the scheme to a ‘self-sufficient’ portfolio of assets is a credible option” (p. 10). If this move is deemed unaffordable, then “benefit/contribution decisions taken at this valuation may need to be re-visited outside of the usual valuation cycle should the trustee need to consider increasing the contribution requirements to respond to adverse developments in the short term risk position” (pp. 10–11).
To assess the sensibility of this approach to short-term risk, we need answers to the following two questions:
Q1. Would it make financial sense to move now to a self-sufficiency portfolio?
The gap between USS’s existing growth portfolio and a self-sufficiency portfolio will often become large precisely when it would make the least sense to move to the latter: e.g., in these months after the Brexit referendum, when a further round of quantitative easing has pushed up the price of, and therefore reduced the yield on, gilts. According to USS’s own analysis of investment returns, now would be an inopportune time to purchase more gilts, when their price has been artificially inflated. For this reason, they recommend against a shift towards bonds during the next ten years.
Q2. Of what relevance is the current cost of a move to self-sufficiency that it would take decades to pay for?
In order to calculate whether the so-called short-term risk to the scheme is too great, USS takes the volatile current cost of moving all the way to a self-sufficiency portfolio. It then compares this with the revenue that would be raised by an increase in employer contributions by 7% of salaries over several decades. If the projected revenue generated over these decades is less than this current cost, USS would like employers to make a rapid short-term response by raising their contributions between valuations in order to close this gap.
Of what relevance, however, is a gap between the amount of revenue that could be generated over several decades and the current cost of moving to a self-sufficiency portfolio? Perhaps if it made financial sense to move to such a portfolio now, and there were a large bank willing to lend USS money to purchase such a portfolio now on a decades-long repayment plan of 7% of salaries, this gap would be of significance. But it makes no financial sense, and there is no such lender.
The principles underlying USS’s approach to risk are therefore seriously called into question by the fact that they might call for an emergency response to close the current gap in affordability to a self-sufficiency portfolio to which it would make no sense to move now. It does not inspire confidence in their judgement that USS is driven by such an arbitrary and ill-justified metric to construct a case for urgent interventions between valuations. If anything good comes of USS’s proposals regarding “short-term risk”, it is that they constitute a reductio ad absurdum of their benchmark of self-sufficiency in gilts, which also underpins their much criticised Test 1.