Risk and de-risking: implications for the USS valuation
Number 57: #USSbriefs57
This is a USSbrief, published on 14 October 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 on 15 August 2018.
Risk can be defined as the probability of injury, damage or loss in a particular context over a given period of time (Sage 1992). In complex financial systems, such as USS, uncertainty complicates quantification of the associated risks. The risk associated with an event can generally be considered to be a combination of the probability of the event and the significance of its impacts (Sage 1992). In addition to real risk, there is perception of risk and the reaction to risk is frequently determined by perceptions.
Decision making about risk and what risks are considered acceptable will generally be affected by a number of different factors, including the following (Hersh 2006):
- The probability, type and severity of the likely consequences. There is often greater concern about events with significant impacts, but low probabilities, such as the risk of dying in a plane crash, where the number of deaths at one time is generally large, than in a car accident, where the statistical risk is much higher.
- Whether the risk has been assumed voluntarily. Most people are less concerned about risks they have assumed voluntarily, such as those involved in risky sports, than risks they are exposed to involuntarily, for instance due to living next to a nuclear power station.
- Whether the risk is to known or unknown individuals, with risks to known people generally weighted more highly and risks to themselves and immediate family, friends and/or colleagues.
- Whether the consequences are immediate or delayed.
As in the case of other complex systems, the risks associated with USS have technical, social and political components. The technical component relates to the likely consequences of risks, whereas the social and political components are concerned with broader, often non-quantifiable, attitudes to these consequences and whether or not they are considered acceptable. In practice it is not possible and generally not desirable to consider the technical and social and political consequences totally separately from each other.
In the case of USS the focus has been on risks to the employers who fund the scheme. However, there are also important risks to scheme members, higher education, research and society as a whole in the UK. It is a mistaken approach to ignore risks in one area while focusing on risks in another. Instead a holistic approach to risk is required. The main risks to scheme members and employers are listed below and risks to higher education and society are then discussed.
Risks to scheme members
- Unnecessary reductions in benefits or increases in contributions due to pessimistic valuation assumptions.
- Affordability problems due to contribution increases, possibly leading to withdrawal from scheme or not joining in the first place.
- Insufficient pension to manage in retirement without other sources of income.
- Pension scheme not paying promised pension when it is due.
- No longer value for money.
- Scheme closure.
Risks to employers
- Poor investment returns.
- Unexpected increases in costs or contributions greater than budgeted.
- Having to pay more than they desire.
- Having to pay more than they can easily afford.
- USS institutions uncompetitive with TPS [Teachers’ Pensions Scheme] ones.
Risks to higher education
UK higher education has an important role to play in the development of both the UK economy and in promoting wider social equality and human development. A pension scheme solely linked to the development of the HE sector and of significant size relative to the sector (the USS scheme’s total value assets are of a similar order of magnitude to the annual turnover of UK higher education), requires a level of obligation by the scheme to the wider social and economic wellbeing of the sector. It should not therefore act to create incentives which are damaging to the sustainability of the sector as a whole. USS therefore needs to recognise that it should not be operated solely as a commercial institution without consideration of its wider responsibilities to society. Its actions should give significant consideration to avoiding distorting the sector and to ensuring it is not having an undue impact on the wider decision making of the participants in the sector. Having created the conditions for the most significant national dispute in higher education to take place is a mark of failure for the USS pension scheme and its management.
Under the current scheme rules many casualised as well as some other lower paid members already face the risks of lack of affordability, resulting in being unable to retire or facing real poverty when they do. Any reduction in benefits and/or increase in contributions will both increase these risks to the members already facing them and increase the percentage of members affected by these risks. These are real rather than perceived risks. The risk of scheme closure also became real and significant with the employers’ DC [Defined Contribution] proposal, but has been minimised by its withdrawal and therefore will not be discussed.
The employers’ risk appetite is important, as it affects the employer covenant and ability and willingness to pay into the scheme. However, the employers’ risk appetite is based on their perception of risk rather than the real risks and there can be a significant difference between the two. In addition, there is a complex relationship between risks to employers, risks to members, and risks to the scheme overall. In particular, any unwillingness by employers to continue to provide the same level of benefits to members transfers risks to members through a reduction in benefits or increase in contributions and this can threaten the scheme overall. There is therefore a distinction to be made between reducing risk and transferring it.
In terms of the risks faced by employers there are both real risks and theoretical model risks. Real risks are largely related to market uncertainties which affect rates of return on investment. Another important source of risk is de-risking which artificially reduces rates of return. This is generally recognised, including by the USS Executive, to lead to an increased ‘deficit’ and a greater need for deficit recovery contributions.
The real risk associated with investment de-risking is not zero. The acceptability of USS investment risks should be assessed both through comparison with the other financial risks engaged in by the employers and the measures taken to keep them as low as possible. Many of the employers engage in a range of financially risky activities, including large building programmes and setting up overseas campuses.
USS’s investments are managed by a very highly expert (and exorbitantly paid) investment team. Although it is not fully possible to predict future performance from the past, this does give an indication of trends and what is likely in the future. Data on investment returns, assets and liabilities show that USS has had a significant positive cash flow over this period and that the rate of increase of its assets is greater than that of its liabilities (USS Annual Reports 2016, 2017).
USS does have investment policies and strategies for both avoiding risky investments and ensuring that target investment returns are met. To date, this has been successful, as evidenced by performance to date, while recognising that past performance is not a guarantee for the future.
USS has a risk management rather than risk avoidance strategy based on a risk appetite set by the Trustee. This determines ‘the target level of risk that USS is prepared to accept in pursuit of its objectives’. Both too much and too little risk can affect objective achievement.
USS has a comprehensive framework for managing risks, including a Group Risk team and risk management processes. With regard to assets, USS has an enhanced due diligence process (Enhanced Due Diligence Team 2014), which aims to identify various different types of risks that could affect ‘the value of infrastructure and private equity, direct and co-investment transactions, pre and post investment’. USS also continues to monitor and manage extra financial factors over the life of an investment. USS’s approach to risk management does not indicate a need to move to de-risking the scheme’s asset base.
De-risking is a process of artificially reducing investment rate of return by increasing the percentage of assets in gilts, which have low rates of return compared to other types of assets, but are considered to be ‘safe’. The perceived low risk associated with gilts is considered to be a consequence of assets and liabilities moving in the same direction when changes occur. However, this does not mean that the reduction in assets cannot be greater than the reduction in liabilities. In addition and more pertinent, it is recognised that de-risking leads to a significant reduction in investment income and thus increases the self-sufficiency deficit and consequently leads to increases in deficit recovery contributions. USS accepts that current plans for de-risking would create a negative cashflow in the scheme within five years. Thus, in real terms de-risking will certainty worsen the financial position of the scheme. It also increases the risk of the following negative outcomes:
- contributions for a given level of benefit being increased above affordability for employers and/or members
- benefits being reduced and ceasing to be attractive to members, leading to withdrawals from the scheme and possibly threatening its viability.
De-risking will involve the movement of a notional theoretical future model risk to employers into real scheme risk for current members. It is also separate from USS’s risk management and extended due diligence strategies. There is no evidence that either these strategies on their own are insufficient or that de-risking improves on them.
Since the valuation date, a period during which there has not been any de-risking, the deficit has reduced by 52%. This is unlikely to have happened if de-risking had been used and shows the potential for eradicating the deficit obtained from the flawed valuation calculations without the need for any action. The difference between the rate of return obtained by the current investment strategy and that allowed by de-risking shows that even allowing for a considerable margin of uncertainty continuing the current investment strategy will lead to much better outcomes than de-risking.
- An appropriate approach to risk management is crucial to avoiding future valuation problems.
- The employers and USS are overly influenced by perceptions of risk related to USS’s model rather than real risk.
- Excessive prudence can be as or even more damaging than excessive risk taking. In the case of USS excessive prudence has been leading to valuation approaches which have created a deficit and required unnecessary reductions in benefits and increases in contributions to manage it.
- De-risking both significantly increases the risks and transfers and transforms relatively small risks theoretical future model risks to the employers to very large real current risks to members
- USS currently has a good strategy in place for managing risks, including through the use of extended due diligence, without any need for de-risking, which anyway increases rather than manages risk.
- Any consideration of USS risk needs to relate it to the very large size and long-term nature of the higher education sector, which generally reduces its significance, as well as the financial risks that the employers routinely accept.
- USS is itself not aiming at zero risk and considers too little risk can be just as much a problem as too much risk.
Enhanced Due Diligence Team [USS Investment Management Limited] (2014) Enhanced due diligence and ongoing management process for infrastructure and private equity investment, version 4.0.
Hersh, Marion (2006) Mathematical Modelling for Sustainable Development. Berlin: Springer Verlag.
Sage, Andrew P (1992) Systems Engineering. Oxford: Wiley.
USS Annual Reports and Accounts (2016, 2017).
This is a USSbrief, published on 14 October 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 on 15 August 2018. 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 #USSbriefs57 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.