How extreme prudence and misguided risk-management sent the USS into crisis

Number 106: #USSbriefs106



Sam Marsh, University of Sheffield

Photo by Michal Matlon on Unsplash

On 3 March, after months of delays, USS revealed the outcome of their 2020 valuation. We’re used to their numbers being off the scale but this time they have outdone themselves. To keep benefits unchanged will, they say, require a contribution of somewhere between 42% and 56% of salary, much of which will be used to cover a huge deficit of around £15bn-£18bn. These figures have the potential to savage pay and conditions and rock the higher education sector. Luckily, they seem to be built on sand.

Checking the health of a defined benefit scheme like the USS, which has to pay out a secure income for each of its members between retirement and death, requires a complex calculation founded on assumptions about the future. Predicting how long people will live often gets the attention, but arguably more important is the prediction of the likely rate of return that contributions invested to pay for the benefits will deliver, the so-called ‘discount rate’. Small tweaks in this assumption can easily turn surpluses to deficits, affordable contribution rates to those of the kind USS served up. So how do USS’s assumptions stack up?

Unreasonable assumptions…

By looking at annual reports as far back as we could find them, Jackie Grant and I have collated and plotted figures for the annual investment growth achieved by USS since 1995 and compared them with the forecasts used in the past decade of valuations (see Figure 1). The results are striking.

Figure 1: ‘Actual asset growth’ is the USS’s historic asset growth calculated from reported investment returns: the asset values plotted are derived relative to the value of the assets as at 31 March 2020 (£66.5bn) adjusted for CPI. Dashed lines show the forecast growth used as discount rates for the scheme’s actuarial valuations in 2011, 2014, 2017 and 2018. The envelope of ‘2020 prudent assumptions’ results from the spread of scenarios USS is proposing for the discount rate in the 2020 valuation dependent on which covenant support measures are adopted. All discount rates are relative to CPI.

While the portfolio has grown steadily in real terms over the past two decades — a period that takes us through the dot-com bubble, the credit crunch, and the market-shock caused by the pandemic — the forecasts used in successive valuations have become progressively more pessimistic. With the exception of the 2018 valuation, each time investments have outperformed the forecasts, the forecasts have been downgraded further. The huge deficits announced by USS result from an assumption that we’ve reached the limit: the investments can no longer be relied on to grow in real terms. Capitalism is dead.

…unacceptable consequences

If that sounds unlikely to you, you’re not alone. Even USS don’t actually think the returns will be so low. In their valuation documents they put the chances of that at around 10–20%. My reading of their figures suggests it may be even lower. This extreme prudence, much higher than USS have used in the past, is the overwhelming source of the low discount rates which lead to the soaring costs and eye-watering deficit estimates (see USSbriefs67). Throw in a valuation date of 31 March 2020, when panic in the markets drove down the value of assets significantly, and you have a recipe for a crisis. (The scheme’s investments have since rebounded significantly, up around 20% from 31 March 2020 to now, a year later.)

Yet again we have a valuation which strains under close scrutiny being used as a basis for contribution increases or benefit cuts. Where in the past this has pitted the scheme’s members against employers in hugely damaging industrial action, hundreds of hours of discussion over the past years and months have brought the two parties together, and both are now calling out the most recent valuation as unjustified. Universities UK, the representatives of the employers, have written to the Chair of the USS trustee board asking for a review of the valuation. What happens next is anyone’s guess.

How did we get here…and what’s next?

If you’re wondering how we got here, let me finish with a little history. In the noughties, choppy equities markets caused large swings in the funding position of the USS. By 2013, a tighter regulatory environment and a change of mood saw the USS board employ the then head of the Pensions Regulator, Bill Galvin, as its CEO. The appointment might have been seen as an attempt to bring the scheme into line with the prevailing direction in the pensions industry. The task was to reduce the scheme’s reliance on growth-seeking assets and follow the orthodoxy of ‘de-risking’ which, among other things, would enable an orderly winding-up of the scheme if necessary (see USSbriefs73). Under Galvin, USS introduced three tests (Test 1 being the most famous) that were sold as a way to manage the scheme’s risks, magically controlling both the contribution rates and the reliance on the employers in a way that should allow an easy exit from the scheme at any point employers were brave enough to try it. A ‘self-sufficiency’ funding level would remain within reach at all times.

But it was too good to be true. If employers believed that USS’s executives had found a way to tame the markets and the scheme, then they were sold a fiction. The reality since Galvin’s appointment has been a succession of valuations in which benefit cuts and contribution increases that employers believed would stabilise the scheme were deemed insufficient almost as soon as they were implemented, requiring more pain at the next valuation. The control over contributions and funding levels that employers might have expected turned out to be an illusion.

The irony is that an approach closer to how the USS had been managed historically may well have led to a decade in which members and employers would have received the stability they craved. That stability would have come from recognising one of the huge strengths of the scheme: that its stable cash-flow position while it remains open to accrual allows it to ride out bumps in the markets that closed schemes feel acutely. By attempting to mimic the management of closed schemes, Galvin’s approach introduced the very instability employers were hoping to avoid.

What we are seeing now is the culmination of the mindset that Galvin brought to the scheme, which brings only a spiral of decline, unaffordable contribution increases and industrial strife. That approach has been a demonstrable failure on its own terms, and members, employers and the sector are paying a heavy price. We urgently need a rethink on how the USS is managed. I’m very glad our intense negotiations with employers over the past year or more have brought us to close alignment on these issues, and that Universities UK are starting to call for change. Better late than never.

This paper represents the views of the author only. The authors believe 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 #USSbriefs106; the author will try to respond as appropriate. This work is licensed under a Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International License.




A set of papers written by University Staff and Students, on University Staff and Students, for University Staff and Students.