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Pensions and the USS dispute: a sustainable social contract

Number 47: #USSbriefs47

Dennis Leech, University of Warwick

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This is a USSbrief, published on 23 August 2018, that belongs to the OpenUPP (Open USS Pension Panel) series. It has been submitted to the UCU-UUK JEP (Joint Expert Panel) by the author on 16 August 2018.

This is the author’s third of three submissions to the JEP. His first submission is #USSbriefs28, ‘USS is a special case: 17 questions for the Joint Expert Panel’. His second submission is #USSbriefs46, ‘The USS analysis of reliance is seriously flawed and biased against the scheme’.

A pension scheme is an arrangement by which an individual can make provision during their working life (usually with an employer contribution) for everything they will need to live on when they have given up working. The principle is simple but its practical implementation raises many problems.

It is clearly impossible to literally purchase the goods and services that will be needed in retirement and put them aside during one’s working life. Even if a person could forecast just what their needs would be after they have retired, something impossible given the uncertainties, the practical difficulties would be insurmountable — and it is anyway impossible to store services. The assumption, found in textbooks of theoretical economics, that individuals maximise a well-defined lifetime utility function defined over a universal domain covering all eventualities, is impossible to reconcile with real life. The idea that a rational agent can choose an optimal consumption and saving trajectory over time is further undermined by the fact that the length of retirement is unknown, since nobody knows the date of their death.

All this is rather obvious. We are therefore left with the fundamental principle that goods and services consumed by the retired must be produced by the currently active workforce. In this sense all pensions provision involves intergenerational transfers, all pensions — understood as the supply of consumer goods and services to the retired — being produced by the working population. All pensions are pay as you go.

How can this relationship between the generations be managed? There are two commonly used principles involving money payments: social contract, or pay as you go, and funding, which essentially entails financial speculation. The social contract approach is very simple: one generation’s pensions are paid for by the working generation, and in exchange their pensions, in turn, will be paid for by the next generation.

The other approach, funding, in which each member pays for their pension out of invested funds they have saved and accumulated over their working lifetime, involves great uncertainty because it is impossible to predict if the market value of the assets will be enough when they are required to provide pensions.

The usual objection to the social contract model is that it may not be sustainable and hence result in intergenerational inequity owing to demographic or economic changes. It is sometimes disparagingly dismissed as a Ponzi scheme if subsequent generations have to pay more than the previous one. However, the design of the pension scheme enshrined in its rules should ensure that it is sustainable and it need not be a cause of intergenerational unfairness. Demographic changes can be managed by the simple rule of regular valuations, for example triennially, allowing trends in longevity and membership to be detected and appropriate changes made.

The question of financial sustainability can be investigated by finding the scheme’s internal rate of return. That is the rate of return on investments required so that the fund is exactly used up at the date of the member’s life expectancy. The fund in respect of each member starts at zero when they join, accumulates when they work, decumulates when they are retired, and goes back to zero when they die. Comparing this required rate of investment return with rates achievable in the real economy tells us whether the scheme is sustainable.

Simple indicative calculations are presented below for various example assumptions about contribution rates, life expectancy, inflation and salary growth. Despite their simplicity, these examples strongly suggest that social contract pension schemes are perfectly sustainable, requiring in most cases only fairly modest investment returns. They also show that the schemes are not too sensitive to longevity assumptions. The results are shown in Table 1 and 2.

Table 1 shows a range of illustrative calculations for final salary schemes. I assume that the member contributes for forty years then retires with an indexed pension of half final salary, plus a lump sum of three years’ pension. This is a typical final salary scheme that was common before the move to career average that has taken place in recent years. A range of assumptions about contribution rates, salary growth, inflation and longevity are considered.

According to the latest Barclays Equity Gilt Study, the average inflation adjusted annual return from UK equities over the past 50 years has been 5.7%. Over the past 20 years, it is 4.6%. The results in the table suggest that the required rate of return is quite low in all cases except where the contribution rate is relatively low and the salary growth and inflation rates are high.

As far as the USS is concerned we can perhaps draw the conclusion from Table 1 columns 9 and 10, which approximate the old final salary scheme that was closed in 2016, that, whatever its undesirable features, unsustainability was not one of them.

Anecdotally, Con Keating reported — at a pensions and USS dispute symposium in May 2018 — that when he asked a senior member of the USS executive what the internal rate of return of the scheme was, he was told it was 4.6%. That seems to be in agreement with the results in Table 1, particularly column 9.

Table 2 presents the calculations for career average schemes. The assumption here is that members pay in for forty years; each year’s contribution is worth 1/75th of the pension, revalued by the inflation rate; the pension is index linked with a lump sum of three times pension. Not surprisingly these findings suggest that the required rate of return is even lower.

Although they are only indicative, assuming a stylised world of steady state growth and inflation, these calculations ought to lead us to question the belief that pension schemes are unsustainable and need to be closed. They undermine the idea that pension schemes have become unaffordable because of low investment returns, when the returns achievable in the real world are higher than those required.

This is a USSbrief, published on 23 August 2018, that belongs to the OpenUPP (Open USS Pension Panel) series. It has been submitted to the UCU-UUK JEP (Joint Expert Panel) by the author on 16 August 2018. 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 #USSbriefs47 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.




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