How to remain invested in the return-seeking portfolio

[Apart from non-substantive copy editing and reformatting, and the redaction of points 11 and 12, this version is identical to my 14 June submission to the Joint Expert Panel’s Phase 2 consultation on the valuation methodology.]

1. It will be difficult to sustain our current DB provision at an affordable level unless the case can be made against the further planned shift, over the next 20 years, of the portfolio away from return-seeking assets (equity and property) and towards bonds, beyond the significant shift that has already taken place over the past 10 years. I therefore hope JEP will be able to make the case for remaining invested in the current reference portfolio over the long term — where this portfolio is roughly two-thirds weighted towards equity and property and one-third weighted towards bonds. The challenge is to make a case that it will be difficult for USS to reject and which will not give rise to insurmountable resistance from the regulator.

2. Test 1 provides USS’s primary justification for their planned twenty-year shift towards bonds. JEP should therefore build on the foundation of the powerful criticisms of this test that were set forth in the first report. It will be useful to begin by clarifying and spelling out USS’s underlying rationale for the test.

3. In a June 2018 blog post entitled ‘Beyond 40 years here be dragons’, which I submitted as evidence for Phase 1 JEP, I reported that USS executives had “informed me that the rationale for Test 1 was to ensure that it is possible to close the DB scheme, within 40 years, with no further contributions needed to be made into the scheme beyond that point”. I have since updated my understanding of the length of the horizon that is assumed by Test 1. As I explain in a February 2019 blog post, I now believe that ‘USS must be planning for the possibility of DB scheme closure in 20 rather than 40 years’. More precisely, I now believe that Test 1 is meant to secure the following:

that it be possible to close the DB scheme by year 20 and fund the accrued liabilities of this closed scheme entirely out of a self-sufficiency portfolio by year 40, with no need for further employer contributions after year 40. During years 20–40, the DB scheme would be closed to future accrual but not funded by a self-sufficiency portfolio. Rather it would be funded by a portfolio which conforms to the requirement of Test 1 in year 20, and which is gradually transformed into a self-sufficiency portfolio via +7% employer contributions during years 20–40.

It would be useful for JEP to seek confirmation from USS that these time horizons reflect their underlying rationale for Test 1. It would also be useful for JEP to verify the accuracy of the following rationale involving regulatory requirements which USS has provided for these time horizons:

The first two pages of USS’s March 2018 response to me provide useful information about their assumptions regarding length of covenant and last man standing. USS maintains that regulatory requirements do not permit them to assume that the scheme will remain open indefinitely. Rather, given the merely finite length of the covenant they’ve established — confidence in strength over at least 20 year, less confident belief in strength during years 20–30, horizon becoming progressively more hazy during years 30–40, and beyond year 40, things go dark — USS appears to be claiming (on my current, updated understanding of what’s going on) that the regulations require a valuation that assumes possibility of DB scheme closure by year 20 and the funding of such a closed scheme entirely out of a self-sufficiency portfolio by year 40.

4. If JEP calls for the complete removal of Test 1, USS will reply that something else will need to be put in its place which serves a similar function. See, for example, the following recent remarks by Guy Coughlan:

Test 1 is essentially USS’s version of the capital adequacy tests that banks and insurance companies are required to satisfy in order to conduct their business and protect their customers. If USS did away with Test 1, we would be obliged to replace it with some other form of capital adequacy test, to protect our members should investment outcomes turn out to be much lower than expected.

Even if JEP is unable to convince USS to replace Test 1 with something else, it will remain possible to press the case that, on a proper understanding of this test, the current return-seeking reference portfolio satisfies it, without need for any further de-risking.

5. JEP should emphasise that, on a proper understanding of Test 1 — and, in fact, USS’s own understanding of it prior to a recent revision of their interpretation of this test — one does not even need to increase “long-term” (year 20) reliance beyond £10 bn in order to justify cancellation of de-risking of the portfolio. In a blog post entitled ‘Test 1 de-risking is dead, long live de-risking!: What’s wrong with USS’s approach to the valuation’, I offer my considered view of how Sam Marsh’s asset projections establish the above claim. (Since I hope JEP members will review it, I have included this blog post as Appendix A to this submission.) In a subsequent blog post entitled ‘The rise in contributions traces to an inexplicable refusal to allow a surplus’, I respond to Guy Coughlan defence of the aforementioned revision of Test 1’s “expected” asset level at year 20 into a “target”.

6. JEP should also make the case for the setting of Test 1 long-term reliance to general salary growth (£19 bn), as USS had previously proposed in their February 2017 consultation. It would be useful to draw attention to USS’s recent claim that it is past conservatism on the part of employers rather than USS, in rejecting £19 bn reliance back then, which accounts for the level of de-risking of the portfolio that has arisen from Test 1. Hence, so long as employers confirm that this is now within their risk appetite, USS should not stand in the way of adjustment of this Test 1 parameter from £13 bn to £19 bn.

7. Even if USS rejects the critique of Test 1 to which I refer in point 5 above, adoption of £19 bn long-term reliance would imply significantly less de-risking of the portfolio during the next 20 years than the current £13 bn reliance assumption implies. In this blog post entitled ‘UUK should now endorse the level of investment risk USS was prepared to accept in February 2017’, I spell out how much lower contributions would have been under the 2017 valuation assumptions if employers had endorsed £19 bn reliance for that valuation: it would have been possible to retain status quo DB, via c. 19% employer and c. 8.5% member contributions, for an overall contribution level of c. 27.5%. With updating of assumptions to March 2018, £19 bn reliance would, I think, make it possible to retain status quo DB at an overall rate of less than 26%.

8. As I noted in point 5, on a proper understanding of Test 1 as involving a prudent expectation of asset levels at year 20, one does not need to argue for an increase in year 20 reliance beyond £10 bn in order to justify a cancellation of a de-risking of the portfolio. Nevertheless, it would serve the following two purposes for JEP to make the case for employer embrace of the maximal Test 1 long-term reliance on the covenant that USS has proposed in the past — i.e., reliance pegged to general salary growth (£19 bn): (a) this would involve nothing other than claims to which USS has itself committed in the past (see points 6–7 above), and (b) it would address concerns that USS has raised regarding “short-term” reliance (see point 9 below).

9. Adoption of £19 bn long-term (i.e., year 20) reliance would address USS’s concern that the scheme’s current (“short-term”) reliance of c. £20 bn — i.e., the current gap between the value of the assets and the cost of purchase of a self-sufficiency portfolio — is far out of line with the long-term target. Adoption of £19 bn long-term reliance would render the current level of short-term reliance in fairly close alignment with the long-term target.

10. JEP should also challenge USS’s other grounds for placing such weight on short-term reliance. This should be a priority, in light of the fact that concerns over short-term reliance (aka the self-sufficiency deficit) have played such a prominent role in shaping the 2018 valuation — both the high level of “upper bookend” deficit recovery contributions and the prominence USS would like the self-sufficiency deficit to play in triggering contingent contributions above the “lower bookend” rate. I provide a critique of the latter in a blog post entitled ‘Why USS lacks grounds for a reliance trigger’. Since this blog post has been privately commended by an actuary closely involved with USS, and since it builds on USS’s “large and demonstrable mistake” over Test 1 that I discuss in the blog post that constitutes the first appendix of this submission, I have included this post as Appendix B of this submission.

{Points 11 and 12 redacted.}

13. Both USS and employers might press the following objection to remaining invested in the current reference portfolio: if the volatile price of return-seeking assets happens to be low, relative to the technical provisions, at the particular 31 March date of a given triennial valuation, this poses a risk of significant deficit recovery contributions. In response, one should first note, as First Actuarial has, that a temporary fall in the value of assets has little bearing on USS’s ability to pay pensions promises as they fall due. USS can hold these assets without being forced to sell them when prices are low, so long as the scheme remains cash flow positive, as is projected for the next several decades. Rather than bearing on the ability to pay pensions when they come due, the risk in question is best described as ‘valuation methodology risk’: i.e., the risk of being forced to recover from a deficit which arises on account of a snapshot of the volatile price of assets on the valuation date which does not reflect the genuine strength of the scheme’s long-term funding position. First Actuarial has proposed the mitigation of such risk by discounting the technical provisions at the internal rate of return (IRR) of equity and property as well as bonds. I offer a defence of IRR in ‘An explanation, via buy-to-let analogy, of First Actuarial’s approach to the valuation of the USS pension scheme’. While it may encounter insuperable resistance from both USS and tPR, it is nevertheless important for JEP to draw attention to the possibility of an IRR discount rate in order to illustrate the extent to which it is on account of the choice of one valuation methodology over another that investment in the return-seeking reference portfolio gives rise to volatility in deficit recovery contributions.

14. On any sensible approach to the valuation, ineliminable risk will remain that returns on a portfolio as weighted towards equity and property as the current reference portfolio will fall significantly short of fully funding the current level of DB pension promise. UCU’s actuary First Actuarial maintains that this risk is sufficiently low that it is reasonable and prudent to take. If UCU agrees with their actuary regarding the low level of risk, then the union ought to be willing to put their members’ money where their mouth is. They should be willing to agree to members collectively bearing at least a portion of this downside risk they are urging employers to bear, by making future accrual at the current level of DB provision conditional on returns being good enough to achieve full funding. If the union is unprepared to make such a commitment to share risks between members and employers, they will be guilty of bad faith in claiming that the risks to employers of funding DB out of a return-seeking portfolio are acceptably modest.

15. Risk-sharing could be introduced along lines of the conditional indexation that First Actuarial originally proposed for Royal Mail, prior to the CDC proposal. USS members currently receive 1/75 career average DB accrual, revalued by CPI each year until retirement. Pensions paid in retirement are also revalued by CPI each year. While remaining in conformity with current UK DB regulations, all of the inflation indexation of 1/75 career average accrual of active members could be made conditional on investment returns not being too low, as could all CPI indexation above 2.5% of pensions in payment. Within that limit that the regulations impose, and hopefully far short of it, JEP should propose a conditionalization of the revaluation of DB benefits just insofar as this is necessary to make it possible to remain invested in the return-seeking reference portfolio while managing the investment risk in a manner that is acceptable to the regulator, USS, employers and scheme members.*

[*] I elaborate on the case for members collectively bearing risk in ‘How to Guard Against the Risk of Living Too Long: The Case for Collective Pensions’, Oxford Studies in Political Philosophy, v. III (OUP, 2017).

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Professor, Dept. of Philosophy, Logic & Scientific Method, LSE

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