Fighting financialisation in USS
Number 107: #USSbriefs107
Deborah Mabbett, Birkbeck, University of London
Another valuation cycle has come round, and USS has produced some new large numbers for the scheme’s deficit, ranging from £14b to £18b. These figures suggest that USS will not be able to pay the pensions it has promised without a substantial increase in contributions (see USSbriefs106). But assessing whether a pension scheme is adequately funded or not is an exercise shrouded in uncertainty. It requires guesses to be made about future investment returns, inflation and pensioner longevity. The regular valuation makes these guesses and throws up an answer, but that answer is only as good as its assumptions and methodology.
Deep uncertainty about the future makes everyone uncomfortable, from contributors to scheme administrators to the regulator. Many in the pensions sector respond to this uneasy predicament by embracing the valuation as the next best thing to godliness, but the valuation process has profound limitations. One of the striking things about the pensions sector is that these limitations are quite well-known and discussed in the professional community, yet valuations dominate the governance of defined benefit (DB) pensions (see USSbriefs57; USSbriefs44).
The regulator, scheme administrators and employers have been caught up in pernicious processes of financialisation (see USSbriefs16; USSbriefs50). This often vague term has a well-defined meaning in the context of pensions, with distinct and traceable consequences. Valuation uses three financial techniques: discounting, mark-to-market pricing, and measuring risk by volatility. Discounting is used to turn the future flow of pension payments into a present value for liabilities, assets are valued at their current market prices, and the risk that assets will be insufficient to meet liabilities in the future is estimated from the past volatility of asset prices.
These techniques allow the uncertain future of pension obligations and fund performance to be reduced to a snapshot in which available information about the future is efficiently compressed into the present, and expressed as a fund surplus or (more often) deficit. It is a remarkable achievement to render an uncertain future calculable in this way, and many users find the performance convincing. Critics have to work hard to chip away at the authority of a valuation. In some aspects, they have succeeded (see USSbriefs106). It is well-known that mark-to-market pricing can be procyclical, exacerbating economic instability. Regulators remain attached to market values, not because those values are right but because they are beyond the control of regulatees. Any deviation from market prices at the valuation date is seen as ‘manipulation’. Consistent models driven by ‘objective’ forces are preferred to messier human processes of debate and negotiation, despite known issues with the quality of the information.
A different problem affects the discount rate. This has to be chosen by those doing the valuation exercise. The choice is biased to low values (inflating the present value of future liabilities) because this is seen as suitably precautionary. ‘Conservative’ assumptions are favoured. Benchmarks for conservatism are drawn from the choices made by other valuers. Few have the courage to stand up for a higher discount rate, even though the precautionary bias that supposedly protects the pension scheme can damage the sponsoring employer. This damage is set aside because the whole exercise is oriented to protecting already-accrued pension rights, with no voice for those who might hope to gain a pension in the future.
Managing the wrong risks
But it is in the estimation of risk that the valuation process descends wholesale into a world of smoke and mirrors. It may seem obvious that the risk that has to be assessed is the risk that the resources of the scheme will not be sufficient to pay pensions as they fall due. But that is not the risk that the valuation process focuses on. It is concerned with ‘valuation risk’: the risk that the current value of the fund is less than its discounted liabilities. This risk is measured as the volatility of the value of the fund, and it can be reduced by investing in assets with less volatile prices: this is ‘de-risking’. This reduction in risk brings with it a reduction in expected investment returns. The effect is that the risk that scheme resources will be insufficient is actually increased by so-called de-risking (see USSbriefs49).
Numerous distinguished economists, statisticians and practitioners have drawn attention to the perverse effects of managing valuation risk rather than managing the meaningful risk that scheme resources might be insufficient to fund the future flow of pension payments. As I document in Reckless Prudence, my recent article in the Review of International Political Economy, the problem was highlighted in the 2000 Myners Review of institutional investment in the UK, and reiterated by John Kay in his 2012 review. The Bank of England has also weighed in, but to little effect. Somehow, attention to valuation risk has proved impossible to dislodge. The Pensions Regulator is totally committed to the central place of valuations in pension fund governance, and over the years it has rewritten the Myners principles to make managing valuation risk a central task of pension fund trustees. Employers are also compelled to pay attention to valuations, particularly since the adoption in the early 2000s of corporate accounting principles that mean that pension fund deficits or surpluses must appear on sponsors’ balance sheets.
In short, defined benefit pensions have fallen into a trap. The trap was designed and built by financial economics, but financial economics has moved on, leaving behind a set of interlocking practices that no policy actor seems to be able to unpick. One response has been to deem the whole setup beyond rescue, and advocate defined contribution (DC) pensions instead. However, as many have noticed, these place a lot of risk on scheme members (see USSbriefs17).
Looking outside the UK, it seems that better solutions can be found when employers and unions keep a firm grip on their schemes and manage to resist wholly financialised governance. Collectively-managed schemes can adopt different approaches to risk management, often involving more flexibility in pension commitments. Paradoxically, the commitment to DB pensions in the UK is exceptionally rigid, closing off pragmatic negotiated risk management. Intergenerational unfairness is one consequence when DB schemes are replaced by DC: those with accrued rights are strongly protected, while new employees are pushed into an insecure DC world.
The current regulatory structure for DB pensions can make it difficult for employers and unions to wrest control of their schemes from the tight grip of scheme administrators and the Pensions Regulator. One escape route is to abandon DB in favour of a ‘collective defined contribution’ (CDC) scheme. The scheme negotiated by Royal Mail and the Communication Workers Union provides some defined benefits, but it avoids much of the burden of DB regulation because there is also scope to vary accrued rights and pensions in payment. In a CDC scheme, valuations are still done, as the trustees have to ensure that successive generations of members are treated fairly. Valuations inform this decision-making, but do not dictate it. They do not determine investment strategy; nor do valuation deficits or surpluses have real effects through corporate accounting. There is a lot to discuss and negotiate in a CDC scheme, and there will no doubt be a temptation to reduce this decision-making to financial formulae, which should be resisted.
Co-operation remains key
The lesson for USS is that employers and unions must continue to cooperate to defend the scheme and challenge the approach taken by scheme administrators and the regulator. A decade after the financial crisis, financialised governance remains immensely influential, despite deeper understandings of its flaws. Trapped in the bizarre play-acting of a defined benefit pension scheme, it is natural to want to leave the theatre. But there is no way that people are better off on the street. Collective governance can bring great rewards despite the difficulty of mediating divergent interests. The challenge for the next decade is to grow out of dependence on the nostrums of finance and reinstate collective control.
Deborah Mabbett was a member of the Joint Expert Panel on USS, which produced two reports in 2018–19. This paper is written in a personal capacity and represents the views of the author only. It draws on her article ‘Reckless prudence: financialization in UK pension scheme governance after the crisis’ published in the Review of International Political Economy, 2020. The author believes all information to be reliable and accurate; if any errors are found please contact us so that we can correct them. We welcome discussion of the points raised and suggest that discussants use Twitter with the hashtag #USSbriefs107; the author will try to respond as appropriate. This work is licensed under a Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International License.