A comment and query for USS’s CEO
Here’s a comment/query I’ve submitted to USS CEO Bill Galvin, in which I challenge Test 1 de-risking. Below I appeal to some Vanguard simulations to illustrate this challenge.
Dear Mr Galvin,
Thank you for your invitation for comments and suggestions in your recent email to members.
Would you please share the following comment and query with your Chief Risk Officer Guy Coughlan?:
The “gilts plus” self-sufficiency portfolio is meant to provide a greater than 95 percent chance of meeting all future benefit payments. According to Test 1, such a portfolio must be within reach of a 7 percent increase in employer contributions.
Therefore the following principle underlies Test 1: employers should have a greater than 95 percent certainty of never having to raise their contributions by more than 7 percent in order to provide promised pensions.
What are the chances that the current return-seeking reference portfolio would meet all future benefit payments if that portfolio were enhanced over decades with an extra 7 percent infusion, above 18 percent, of employer contributions?
If those chances are greater than 95 percent, then the current reference portfolio already satisfies the principle underlying Test 1, and there is no call to engage in its expensive de-risking away from equity and towards gilts, during the next twenty years.
I elaborate on the above in {these three blog posts}.
Yours sincerely,
Michael Otsuka
Professor of Philosophy and member of the Pensions Advisory Group, London School of Economics
The above is an attempt to test my hypothesis that there’s a less costly means than Test 1 de-risking to manage the downside 5% risk. As a means of illustrating this hypothesis, see the following simulations by Vanguard of three portfolios.
• The top turquoise 80% equity and 20% bonds portfolio is roughly along the lines of USS’s current return-seeking portfolio.
• The middle purple 60% equities and 40% bonds portfolio is roughly along the lines of the de-risked portfolio after 20 years.
• The bottom green 20% equities and 80% bonds portfolio is roughly along the lines of a “gilts plus” self-sufficiency portfolio.
The vertical endpoint of the left whisker is the downside 5th percentile performance, where the real returns are -4.0% for the return-seeking portfolio and -2.1% for the self-sufficiency portfolio. If an annual infusion of a 7% extra employer contribution into the return-seeking portfolio would be sufficient to close that gap in performance, then it already satisfies the principle regarding risk management that underlies Test 1.
It is also important to note that, insofar as the low 5th percentile return is the result of a drop in asset prices as opposed to income from these assets, that will not prevent a cash flow positive scheme such as USS from meeting its pension promises.
