Employers should endorse USS’s proposed relaxation of Test 1

In this linked consultation document on the valuation, USS offer UK university employers a way to retain the current 18% level of employer contributions while avoiding a new round of cuts to pensions. This involves (i) an endorsement of the least restrictive interpretation of ‘Test 1’ offered in 4.4.1-4.4.3 of the consultation document (click here for an explanation of Test 1), and (ii) an increase of the assumed return on Test 1’s ‘self-sufficient’ low-risk investment portfolio from gilts plus 0.50% to gilts plus 0.75%, in the manner sketched in 4.4.4. (See here for more on ‘self-sufficiency’.)

USS maintain that, on this approach, the ‘required [employer pensions] contributions can be lower [than the roughly 35% they would be charged under the 2014 valuation assumptions], but the employers are accepting greater levels of risk: if the assumptions adopted turn out to be too optimistic then future contributions will need to rise’ (p. 9). USS caution that employers ‘may prefer a lower level of risk to be taken because although affordable in extremis, they wish to reduce the chances of being required to pay higher contributions in future which could impact adversely on business plans’ (p. 17). In USS’s framing of things, employers are therefore presented with the following dilemma: ‘Employers will need to decide how much risk they wish the trustee to take on their behalf. Taking the most risk keeps the current price of pension low but if the forecasts prove too optimistic then employers risk having to pay more than they are comfortable with in future.’ (p. 6)

A strong case can be made, however, that USS overstates the long-term risks to employers of adopting (i) and (ii) above.

Re (i), USS is simply endorsing the sort of flexibility regarding the interpretation of its self-imposed Test 1 that is broadly along the lines that Aon Hewitt urged in the employer’s own submission for the 2014 valuation, as a means of avoiding ‘needlessly layer[ing] prudence upon prudence’. Employers should endorse the least constraining interpretation of this test that USS is willing to offer. They should do so in order to avoid an excessive layer of extra prudence that is based on an unsound case for an expensive ‘de-risking’ of the assets in the scheme.

Re (ii), in their discussion of the extent to which a self-sufficiency portfolio should resemble an insurance company’s annuity portfolio, USS makes reference to the requirements of a “closed pension plan” (p. 25, point 2, emphasis added). In its documents in justification of Test 1, however, USS never refers to what would be necessary to close the defined benefit (DB) plan. Rather, in USS’s words, “The ‘self-sufficiency’ measure of the liability reflects the required level of assets to meet all future benefit payments to a very high probability without the need for additional contributions” (“Proposed Approach to the Methodology for the 2017 Actuarial Valuation”, p. 10). Such a definition of self-sufficiency is perfectly consistent with the plan’s remaining open.

This linked updated cash flow projection chart from First Actuarial suggests that, as a result of the recent cuts to DB pensions, the scheme will remain in positive cash flow for the next 60 years. For reasons which are mentioned below in numbered excerpts from First Actuarial’s submission to the 2014 valuation, such positive cash flow greatly diminishes the risk of remaining invested in return-seeking assets such as equity:

6.7 While the net cash flow is positive, there is no need to sell any assets and therefore no disinvestment risk to the USS. Low market prices are beneficial during this {…} period of positive net cash flow [because assets are being purchased more cheaply], so a measure of risk which suggests a market fall is a problem would be giving a wrong message.

6.8 While there is no requirement to sell assets, volatility from market value fluctuations is not a concern for the USS: the main concern is the volatility in asset income. Measures of risk and funding level which are market value sensitive, as opposed to asset income sensitive, are likely to be inappropriate in this context and should be given little attention.

6.10 In the >99% likely scenario of USS continuing as an open scheme sponsored by employers with a robust covenant, the issue of very high relevance is the rate of growth of asset income. Income uncertainty, not market value volatility, is the key issue for the scheme.

As we can see, moreover, from graphs such as the following, dividend income from equity is much more predictable and less volatile than the asset price:

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Source: Robert Shiller, Irrational Exuberance, 3rd ed.

So long, therefore, as the pension scheme is valued in a manner that is sensitive to these more modest fluctuations in investment income rather than the greater volatility of asset prices, it seems unlikely that an in extremis scenario would emerge in which a funding shortfall becomes so great that employer contributions would need to rise to an unaffordable level. See p. 7 of the linked document prepared by First Actuarial, which applies such an approach to the valuation to USS, and see also this blog post for further discussion of its rationale.

If USS’s DB plan is allowed to remain open and ongoing, the large, steady, and reliable cash flows from regular contributions render fluctuations in dividend income from return-seeking assets much easier to manage than they would be in the portfolio of an insurance company that is entirely reliant on income from investments to pay out its annuities. USS’s current reference portfolio is weighted towards return-seeking assets (63% equities and 7.5% property). For an ongoing scheme such as USS with a strong covenant which is projected to be cash positive for several decades, such a portfolio should be able to deliver a given level of benefits with at least as high a probability as could be delivered by USS’s suggested gilts-heavy low risk portfolio for their self-sufficiency valuation. That’s one of the main points of this paper that First Actuarial released in December, about which please consult this blog post and this follow up to that post.

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