Industry debate and USS’s phantom deficit

Number 34: #USSbriefs34

Woon Wong, Cardiff Business School

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This is a USSbrief, published on 12 July 2018, that belongs to the OpenUPP (Open USS Pension Panel) series. The contents were submitted to the UCU-UUK JEP (Joint Expert Panel) by the author.


1. Summary of letter to Times Higher Education, 5 July 2018

As pointed out by the Pensions Regulator, at present there is an industry debate on whether gilts are representative of other assets such as equities. According to a recently completed working paper by Woon Wong of Cardiff Business School, gilts yields are driven by factors that are entirely different from those that determine the returns on equities.

Consequently, gilts are no longer appropriate for the valuation of the liability of a DB (defined benefit) scheme. Despite the USS’s repeated denials of using gilts for its valuation, the working paper shows that interest rates explain up to 99.3% of variation of past liabilities of USS.

Although falling interest rates have been suspected as the reason for the USS’s deficits in recent years, it is either difficult to prove it, given the opaque valuation process, or to argue against it, as the public has been persuaded to accept a pessimistic outlook which is actually unjustified. The working paper provides the required proof and argument against the flawed valuation method adopted by USS. Using an appropriate valuation technique, the USS is found to be in surplus as large as £10bn, on a prudence basis.

Full text of ‘Phantom deficit’, letter to Times Higher Education, 5 July 2018

Screenshot from Times Higher Education website

Materials submitted to the JEP:

  • Email from Woon Wong to JEP, 18 June 2018 (reproduced below as Section 2)
  • Wong, W.K. (2018) ‘The phantom deficits of USS pensions’, Cardiff Economics Working Papers E2018/12, Cardiff University, Cardiff Business School, Economics Section.
  • Wong, W.K. and Dixon, H. (2018) Summary article of ‘The phantom deficits of USS pensions’ to JEP (reproduced below as Section 3)

2. Email from Woon Wong to JEP, 18 June 2018

From: Woon Wong wongwk3@cardiff.ac.uk
Sent: 18 June 2018 14:41
To: submit@ussjep.org.uk
Subject: On USS valuation

Dear JEP

I attach my recently completed working paper on USS. Also attached is an article summarising some of the key findings [Ed. note: see Section 3 below]. I believe that my latest findings in the financial economics of long term expected returns on equities and fixed income are particularly relevant to the panel.

I can show that de-risking is not only sub-optimal, but could create more risk in the current low gilt-yield environment. This also implies that the 3 tests and the concept of self-sufficiency need a fundamental re-think.

Instead of rushing into any decision to change the current status quo of USS, I suggest the following:

  1. Drop the gilt-based valuation approach. While USS may claim its existing method is not, the fact that the self-sufficiency portfolio is using gilt+0.75% as its discount rate essentially makes it a gilt-based valuation.
  2. The valuation methodology should be grounded on both theory and evidence. Section 5.2 of the working paper shows clearly the gilts plus method is inappropriate, and that the discount rate should be constructed using capital asset pricing theory, which has been well established.
  3. The controversy surrounding the valuation of USS is far simpler than that faced by Brexit. We academics as well as the pensioner practitioners certainly can agree a rational and optimal way forward. All is required is time — say 2 to 3 years of proper research and discussion between all relevant academics, the actuary industry and the Pension Regulator (of course these include UUK and UCU).

I am happy to present my findings (include new results not shown in the attached files) and answer any question should the panel requires me to do so.

Yours sincerely

Woon Wong, PhD FRM
Reader in Financial Economics
Director of Trading Room Operations & Development
Cardiff Business School


3. Wong, W.K. and Dixon, H. (2018) Summary article of ‘The phantom deficits of USS pensions’ to JEP

Contrary to public perception, Universities Superannuation Scheme (USS), the largest defined benefit pension in UK, is more likely to be in surplus rather than deficit. The problem with the recent years of reported deficits of USS lies with the methodology by which the value of liability is determined. In the 2017 valuation, USS is reported to hold £60bn of assets. Since it is essentially the investment returns on these assets that will pay for the promised benefits, the discount rates used to obtain the value of liability should reflect the rate of return on the assets. (The discount rates refers to the rates at which future promised benefits are discounted in order to determine the value of the liability. In practice, the discount rates can be set as the rate of return on USS portfolio minus 1.1% to allow for prudence.) The methodology used by USS to obtain the value of liability and discount rates is ‘complex’, as described by the Pensions Regulator (tPR). The process starts by establishing the liability of a self-sufficiency portfolio and then subtracts various amounts from it to obtain a value for the so-called technical provisions or liability. For comparative purposes, these constructed discount rates are calibrated relative to gilts. Despite its complexity, a recently completed working paper of Cardiff Business School shows that a single interest rate, specifically the yield on long-dated index-linked gilt, explains up to 99% variation of past USS liabilities between 2011 and 2017. Figure 1 plots the USS liability in £billions (blue dots) against the long-dated index linked gilt yield. The orange curve is the liability obtained using a discount rate given by the same gilt yield plus a constant.

This is surprising since USS has repeatedly denied the use of the gilts plus approach (typically meaning a fixed margin above gilts) for its valuations. A careful study of the 2017 valuation documents reveals that while USS is technically correct to make such denials, its view and method of obtaining the discount rates track closely the interest rates, which have fallen sharply in recent years. For instance, USS believes that it would take ten years for the current low interest rates to revert to a normal level; correspondingly, the first ten years of discount rates average only 0.93% per annum. A new method called the Fundamental Building Blocks is used and the discount rates are expressed relative to CPI inflation instead of gilts in the 2017 valuation, reducing the liability by £5.2bn to £67.5bn. While the reduction seems large, according to the estimated model, it corresponds to merely a rise of discount rate by 28 basis points, just over a tenth of the fall in gilt yields between 2011 and 2017. Moreover, half of the reduction is attributed to change in demographic assumptions rather than reassessment of the discount rate.

The Employers Pension Forum recently remarked on the funding position of USS that ‘as well as being sizeable, the deficit is volatile and this volatility poses additional risks to the security of the USS’. However, the large and volatile deficits are the result of using a discount rate that is predicated on falling interest rates. Basically, since the liability is valued in a similar way to bonds with gilt yield as the discount rate, the slope of the relationship between the value of liability and interest rate steepens as the latter declines, as is noticeable from Figure 1. For example, the slope is -10.2 when the index-linked gilt yield in 2011 was 0.71%, but steepens to -18.8 in 2017 when the yield fell to -1.68%. To put it into context, a 10 basis point fall in yield would increase the liability by £1.02bn in the former; six years later, the same amount of interest rate fall results in £1.88bn rise in the value of liability.

Is there any evidence that USS can use to justify the close association between its low discount rates and gilt yields? This question highlights the current debate in the pension industry as mentioned by tPR in its 2017 annual funding statements for defined benefit schemes. According to the working paper, gilts are inappropriate for the valuation of defined benefit schemes because they are driven by factors that are entirely different from those that determine the returns on equities, which constitute 60% of assets held by USS. Because of high inflation during 1970s and 1980s, the returns on gilts and equities are comparable and hence the former were suitable discount rates for defined benefit schemes. Successful monetary policies and other economic developments, however, have brought stability to prices, resulting in long term decline of riskless interest rates. With zero lower bound on policy rates, the long-dated interest rates fall further due to quantitative easing as central banks try to stimulate the economies after the recent financial crisis. Other factors such as the savings glut by China and liability-driven investment of pension funds also contributed to the decline, rendering the gilt yields depressed relative to the economic fundamentals. On the other hand, the returns on equities are the result of the productivity of firms in the real economy. As the American economist Frederic Mishkin points out, price stability and economic growth are mutually reinforcing, the long term nominal stock market returns in both UK and US have stabilised at about 7% to 8% in the past three decades.

The capital asset pricing theory established by Nobel Laureates Sharpe, Markowitz and Miller can be used to form the required discount rate to value the liability of USS. Based on the theory, the long term expected rate of return on USS portfolio is estimated as 5.7%. Subtracting 1.2% for prudence produces a discount rate of 4.5%. Note that the fifty years of varying discount rates provided by USS average to only 3.27%. While the difference between the two discount rates appears small, the long term compounding effect is large. Using the former discount rate, the surplus of USS can be as large as £10bn. (Contingent on the assumptions of the model and other estimates, it is perfectly plausible that the stated surplus be reduced or increased by several billion pounds. In either case.) The possibility that USS is in large surplus can be appreciated by considering Figure 2 which plots the discount rates (USS) associated with the reported liabilities between 2011 and 2017. Also plotted are the average return realised by USS assets over the period and the average discount rate of the state employees’ defined benefit schemes (NASRA) in the US. In the past seven years, the assets of USS has been growing at a considerably higher rate than estimated by its own discount rates. The implication is that, for example, the deficit identified in 2011 may well have already disappeared a few years ago if the liabilities had not been overstated by falling interest rates. Finally, the difference between USS and NASRA discount rates should not be large since portfolios nowadays are internationally well diversified. Putting aside the possible reasons for the difference, the rapid decline of the latter clearly illustrates the extent to which USS liabilities have been overstated.

Dr Woon Wong, Reader in Financial Economics, Cardiff Business School
Professor Huw Dixon, Professor of Economics, Cardiff Business School

24 May 2018


This is a USSbrief, published on 12 July 2018, that belongs to the OpenUPP (Open USS Pension Panel) series. The contents were submitted to the UCU-UUK JEP (Joint Expert Panel) by the author. This paper represents the views of the author only. 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 hashtags #USSbriefs34 and #OpenUPP2018; the author will try to respond as appropriate. This work is licensed under a Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International License.