Increasing student enrolment would kill DB for no good reason

Another significant flaw with USS’s Test 1

USS’s much criticised Test 1 has the following further surprising upshot: increased hiring owing to increased revenue from expanding student numbers would force the closure of DB for no good reason by gratuitously triggering an expensive shift of the pension fund’s portfolio from growth assets to low-return bonds.

Here’s why. According to Test 1, it must be affordable, via a 7% increase in employer contributions over two decades, for USS to purchase a low-return, bond-weighted “self-sufficiency” portfolio that provides the same absolute level of returns as the growth portfolio that would be sold in exchange for this self-sufficiency portfolio.

More precisely, USS calculates the absolute amount of extra cash that would be generated from a 7% increase in contributions (i.e., from 18% to 25% of salaries) this year. USS then assumes that this amount will grow each year in real terms (CPI) over the next 40 years. It then adds up the extra cash generated, on this assumption, by a 7% increase during years 20–40. According to their calculations, this adds up to £13 bn.

According to Test 1, the gap, in 20 years’ time, between the value of USS’s actual portfolio and an equivalent self-sufficiency portfolio must be no greater than £13 bn. USS has actually applied an extra layer of prudence and adjusted this downward to £10 bn.

This requirement makes no allowance for growth in the sector that might arise from expanding student numbers. Suppose that, as the result of successful efforts to widen participation in USS’s pre-92 universities, student numbers double over the next twenty years, as does the number of university employees who are USS members. Other things equal, this would double the amount of extra revenue which could be generated via a 7% increase in contributions. But Test 1 makes no allowance for this. Rather, the more the pre-92 sector grows, the greater the Test 1 demand to shift the portfolio from growth assets to bonds as it shoehorns a growing pension fund into the absolute confines of £10 bn. This would make DB prohibitively expensive and force its closure for no good reason. There would be no good reason, since an expansion in staff supported by an expansion in student numbers does not make a pension scheme more risky, less affordable, and less sustainable. Even if such expansion adds a certain amount of risk to the scheme, it does not do so to the extent that an inflexible Test 1 implies, on account of its insensitivity to growth in the number of employees in the scheme. It does not present such strong reason to shift from growth assets to bonds.

Please give Professor Susan Cooper, Oxford’s former UCU pensions representative, credit for drawing a closely related problem with Test 1 to my attention. In private correspondence, she noted the following:

Test 1 REALLY condemns DB because the offset allowed to self-sufficiency only grows with CPI, whereas the size of the fund grows [additively] with all the contributions, at least until USS is old enough that members are dying at the same rate as new members joining. So if all else were to stay the same, the distance to self-sufficiency would grow in proportion to the total size. This means Test 1 will put an increasingly tougher limit, eventually dooming DB even if we get by this valuation round. And they are actually proposing to make Test 1 worse, keeping the limit at £13bn but introducing £10bn as the target!

Note that Cooper’s comment remains valid even if we do not assume increased hiring due to an increase in student numbers. She merely speaks of the effects of the maturing of the scheme over time, without assuming any sector expansion.

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

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