A response to Kevin Wesbroom’s query regarding Test 1
On Twitter, Kevin Wesbroom has asked Sam Marsh and me a question about our critique of USS that arises from Sam’s findings. Here are Kevin’s tweets, and my reply below:
I would characterise Sam’s and my critique differently:
According to USS, Test 1 serves as a measure of reliance on the employer covenant, which they define as “the difference between the assets held by the scheme to fund the promised benefits, and those required by a low risk investment portfolio (a funding approach known as self-sufficiency)” (Sept 2017, p. 40; see also pp. 26, 34 and 58).
Test 1 is meant to provide the measure of the above difference at year 20 — i.e., 31 March 2037 (which is 20 years beyond the 31 March 2017 valuation date).
The assets held by the scheme on 31 March 2037 must be of sufficiently high market value that it is possible to purchase a self-sufficiency portfolio by year 40 (i.e., by 31 March 2057), via supplementation of the assets by +7% (i.e., a rise from 18% to 25%) ‘contingent’ employer contributions from year 20 to year 40.
What I say above is either stated in or implied by USS’s Sept 2017 consultation document. (USS states some things somewhat differently in their Nov 2016 valuation discussion forum document. But I am taking the Sept 2017 consultation document, rather than that earlier document, as the authoritative statement, when the two documents are in conflict.)
I should note that the following two interrelated aspects of USS’s approach are stated unclearly in their documents and are therefore widely misunderstood: (i) the 20 years of +7% contingent contributions would be paid from years 20 to years 40 (2037–2057), and (ii) there is no requirement that it be possible to purchase a self-sufficiency portfolio before year 40 (2057). (USS executives have confirmed these two points in discussion or correspondence with me. See, e.g., this blog post.)
Having set out my above understanding of USS’s approach, I’m now in a position to respond to your query regarding whether Sam’s and my critique of USS implies bullet de-risking at year 20.
My answer is ‘No’. On our shared understanding of USS’s approach, there would, in fact, be no call for any de-risking of the portfolio between now and year 20 — neither gradual nor bullet. Reliance on the covenant would be within the permissible £10 bn range at year 20 even if the scheme remains invested in the current, non-de-risked reference portfolio for the next twenty years (and also thereafter).
Note that USS’s definition of reliance on the employer covenant — i.e., “the difference between the assets held by the scheme to fund the promised benefits, and those required by a low risk investment portfolio (a funding approach known as self-sufficiency)” — makes no reference to the composition of the “assets held by the scheme”. It leaves open whether that composition is along the lines of the current reference portfolio or de-risked towards greater weighting in bonds that USS would like to achieve over the next 20 years. The “difference” referred to in this definition of reliance is the difference in the market value of the assets held by the scheme and the market value of a self-sufficiency portfolio. (I say more about this here.)
Where — according to Sam and me — USS goes wrong is in concluding that reliance on the covenant would be too great at year 20 (i.e., in excess of the permitted £10 bn gap between assets held by the scheme and self-sufficiency) if we remained invested in the reference portfolio, with no de-risking between now and year 20 (bullet, gradual, or otherwise). They go wrong in concluding this because they mistakenly assumed that the value of column 1 of row 1 would be the same as their calculated value of column 2 of row 1 here:
[UPDATE: Please see here for Sam Marsh’s response to Kevin’s query.]
