Is there really a USS deficit?
Number 7: #USSbriefs7
Is there really a deficit? Yes and no. UUK (Universities UK) have said the scheme is in deficit; the deficit is growing; and the deficit is unsustainable, because its growth means the employers will have to make ever larger recovery payments.
Let us examine UUK’s claims. First, the USS (Universities Superannuation Scheme) is not in deficit in the ordinary meaning of the term. Second, there is no evidence to support the claim that investment returns are too low for the scheme to be sustainable. Third, the scheme is demonstrably sustainable as long as it remains open. Fourth, it is highly questionable that there is a deficit even in the narrow technical meaning in which the word is being used here.
1. The USS is not in deficit in the ordinary meaning of the term.
The ordinary meaning of a deficit is that there is not enough money coming in to cover the payments out. We think of a pension scheme as in deficit when the contributions and the income from investments are inadequate to pay the pensions of retirees, and there is thus a need to sell investments to fill the gap, or an employer bailout.
That is not the situation of the USS, as can be seen in Figure 1, a table produced for the 2017 USS Annual Report. Income from contributions by employers and members in the year totalled £2 billion, while pensions in payment came to £1.8 billion.
In addition to this surplus on contributions, the scheme made a return on its investment portfolio of £10 billion. This came mainly from market price movements (which could as easily go down as well as up), but the figure includes over £1 billion in dividends, interest, rent etc. Rather than facing a deficit then, USS is cash rich. Every year it invests its surplus in expanding its portfolio of new assets such as, recently, large stakes in Thames Water, Heathrow Airport, and other infrastructure projects, in addition to traditional investments like company shares and bonds.
Figure 1: There is no cash-flow deficit
Looking at one year’s figures (or even several years’) is not enough to dismiss claims of a deficit, since they may not give a complete picture. A deficit could emerge in the future when conditions change, or a situation could develop where the pension promises cannot be fulfilled. It is thus necessary to predict whether there will be enough money to pay the pensions when they come due, fifty years from now, when young lecturers, who are early in their careers in 2018, have retired. How much that will cost can be forecast on assumptions about how long people will live in retirement, future salary growth, price inflation and other factors. That is the job of the actuary.
The actuary’s forecast can then be used as the basis for determining how much will be needed to be invested today to yield enough of a return in 50 years to pay the expected pension. The rate of return on this theoretical investment is called the discount rate. It is a reverse compound interest rate.
Since the trustees have to be sure that the money will be there, they must be prudent in their assumptions about the future and in their investment strategy. How prudent is prudent enough? Since nothing is ever certain, if they wish to be very prudent, they cannot rely on contributions from employers or members in the future. Theoretically the scheme could close (maybe all the member institutions go under or stop supporting the scheme for some reason we do not yet know) and there could be no contributions. So it is arguably better to err on the safe side and assume that contributions will end. This assumption has significant consequences for the analysis, as I will show.
When it comes to investments, prudence would appear to entail avoiding risky assets like equities (even though they are almost certain to grow handsomely in a long enough period) and investing in supposedly more secure bonds, which have a poor rate of return. At the moment, the rate of return on government bonds is at a record low level due to the government’s policy of quantitative easing. The USS Investment team expect the return on index linked bonds to be 1.2 percent below CPI (Consumer Price Index) inflation (actually negative in real terms), compared with 3.5 percent above CPI inflation on equities.
Doing this calculation for all prospective pension payments, into the distant future, gives a figure for the scheme’s liabilities. Comparing that with the value of the scheme’s assets gives the funding level or deficit/surplus. The deficit is thus a technical term relating to this theoretical experiment, rather than an ordinary deficit. The liabilities figure is very large because it is based on the very powerful arithmetic of compound interest over long periods of time. For the same reason, it is also very sensitive to the assumptions made in calculating it. And it must ignore a host of real world factors that can change dramatically.
The figure for the deficit is inaccurate and volatile because it is the difference between two very large numbers, the liabilities and the assets, each of which is highly volatile. The liabilities figure, even on its own, is an extremely noisy measure. The deficit figure quoted by UUK and USS changed by over £2 billion in little over two months. This fact alone suggests that this way of valuing the scheme is unreliable: the true value of the pension benefits (if it could be estimated) cannot have changed in that time by more than a miniscule amount.
Another problem with this approach, that has not been sufficiently discussed, is that it begs the question of how the capital value of the assets is to be converted into money to pay the pensions, which are an income stream. That process needs to be spelled out and not just assumed. Can a scheme as big as the USS just sell assets on a large scale if need be without disturbing the market? It seems unlikely. The calculations and assumptions which USS and UUK are making, or failing to make, about the closure of the scheme do not seem entirely reliable.
2. There is no evidence that investment returns are too low for the scheme to be sustainable.
One of the reasons UUK gives for the deficit is the decrease in investment returns. It is certainly true that government bond (gilt) rates are at the lowest they have ever been, lower than inflation. It would not really be sensible for a rational investor to invest in gilts since that would guarantee losing money. (Although that is precisely what USS is being advised to do in the name of ‘de-risking’!) But other investments, particularly equities, produce a good return that would seem to be enough for the pension scheme to remain viable, if it continued to invest in them.
Figure 2 shows the estimated returns on different investments that were prepared for the UCU (University and College Union) by its actuarial adviser. They contain a suitable margin for prudence to enable them to be the basis of a discount rate. The returns have fallen dramatically to low levels on bonds, particularly government bonds. Thus the deficit claim should not be based on arguments dependent on decreased investment returns.
Figure 2: Poor investment returns?
3. The USS is sustainable if it remains open.
Another, simpler way of predicting whether the defined benefit scheme will be able to make pension payments fifty years in the future is to ask if there will be enough cash flow to do so, based on a projection of income from contributions and investment earnings and liabilities. Using cash flow is a natural, direct approach that requires less in the way of assumptions than the capitalisation approach described above. In particular, it does not require a discount rate for compound interest calculation.
Figure 3 shows projected cash flows for the USS that have been prepared for UCU by its actuarial adviser. This is just one of many scenarios that have been studied, but all show the same picture (the one illustrated assumes 2% real salary growth and modest real investment income of 0.2 percent). It is clear that from this point of view, where the scheme remains open indefinitely, it will be perfectly sustainable, having a small deficit or surplus, but without any tendency to increase without limit.
Figure 3: Unsustainable?
4. The scheme may not be in deficit even in the narrow technical sense.
There is a fundamental difference in the methodology between the situation where the scheme is assumed to be open indefinitely and where it is expected to close at some point. If it is expected to close, it must find a way of ensuring it is funded at all times, or at least as soon as possible while it can rely on the employer being able to support it. Volatility of the technical ‘deficit’ due to market fluctuations in asset prices represents a major risk here. The risk is that the scheme will close, because the employers cease to support it, and the valuation will then crystallise, at a moment when asset values are low due to a depressed market, such that they are inadequate to pay the liabilities. Hence the need for recovery payments to meet the cost of covering this risk.
On the other hand, if the scheme is open indefinitely with a strong employer covenant, it can be assumed it will never need to close. In this case, short term asset price volatility is not so important. The ability of the scheme to pay benefits depends on there being sufficient investment income and contributions from employers and members coming in. Therefore market volatility is not a source of risk. There is much less risk and therefore the scheme is cheaper because there is less need to cover this risk. Also the scheme does not need to invest in ‘safe’ assets like gilts for the same reason. An open scheme can and should invest in assets that bring the highest return.
Figure 4 below (from the USS Technical Provisions Consultation document, September 2017) is the analysis, by the USS executive (not the UCU actuary this time, but the USS executive itself, under its requirement to provide a fair view of the scheme), of the ‘deficit’ based on these two different assumptions. On the assumption that the scheme may have to close and therefore must be extremely prudent, so called ‘gilts plus’, the ‘deficit’ is £5.1 billion. (This has been changed since the TP document was published and is now £7.1 billion. This is the change from the September to the November basis that is a focus of the negotiations. The volatility of these figures calls into question the whole methodology, which values pension liabilities at amounts varying billions from months to month, when in reality they change very slowly over decades.)
If the scheme remains open, by contrast, there is no need to apply such a great layer of prudence to all the calculations, and the valuation of the liabilities can be done using the ‘best estimate’ of the investment returns as the discount rate.
On this basis the scheme is massively in surplus: to the tune of £8.3 billion! Curiously, in Figure 4, the USS portrays this surplus as a negative deficit!
Figure 4: ‘Deficit’ or ‘Surplus’?
All the efforts of the scheme trustees, the employers and the pensions regulator should be devoted to ensuring the scheme remains open. The biggest threat to the scheme comes from the deficit recovery payments calculated on the basis that the scheme might close. It is therefore something of a self-fulfilling prophecy. If the scheme is assumed to be ongoing and open then there is little risk.
The problem with the methodology that is being used for the valuation is that it is based on an assumption that risk is the same in all circumstances. That is a theory which is false empirically. But risk is not an absolute exogenous quantum, as some suggest. It is contextual. And assumptions about it are self fulfilling.
Postscript. Why can’t the Pension Protection Fund help?
What is puzzling is that the methodology takes no account of the safety net provided to all pension schemes by the PPF (Pension Protection Fund). The USS contributes its share of the levy to this government scheme, which guarantees pensions in payment and ensures active members will receive pensions at 90 percent of the DB scheme level. Why does the USS valuation ignore this? It seems directly relevant, since the PPF manifestly limits the risk.
It is said that if the USS entered the PPF, it would be too big for it. But the PPF would take on the assets as well as the liabilities. Since the PPF is a government body, there can be no problem of it failing to support the schemes in its portfolio, as there is with a private-sector employer with a weak covenant. Short-term market volatility would not pose any risk.
Therefore we can argue that if the USS is protected by the PPF, a statutory body supported by government, the greatest part of its risk is removed. The valuation need therefore be done without such a large amount of prudence, and therefore the deficit will be much smaller or non-existent. Therefore the scheme is not in danger of failing and of having to enter the PPF. Can anybody explain why this argument is not being used?
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 hashtag #USSbriefs7; the author will try to respond as appropriate. This work is licensed under a Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International License.