Is investment weighted towards growth assets intergenerationally unfair?
A response to USS’s claim that it is
As discussed in a previous blog post, UCU and UUK have asked USS to model “an option involving a higher-return (and higher-risk) investment strategy”, in which the scheme would remain continually invested for the long run in a portfolio which is weighted roughly 65% in “growth assets” (equities and property). In that earlier post, I responded to USS’s objection that the “short-term risk” of such an approach was too high.
In this post, I respond to USS’s distinct objection that such an approach is intergenerationally unfair:
We believe that this option does not align well with Principle 3 [regarding intergenerational fairness]…. This is because in effect more risk is being taken to meet pensioner liabilities and, if that risk materialises, the cost increase would be split between employers and active members under the cost sharing rules in the absence of an alternative JNC decision. This is challenging in terms of intergenerational fairness. (‘Methodology and risk appetite for the 2020 valuation’, March 2020, p. 38)
Here is Principle 3:
The scenario USS has in mind is one in which returns on growth assets are not as high as expected, and contributions must rise in order to recover from the associated deficit on the funding of past pensions liabilities. This rise would be in spite of the fact that contributions on this approach will have already been set so as to ensure a greater than USS’s currently required two-in-three chance of covering all pensions liabilities. The upshot of such a funding shortfall is that future generations would pay higher contributions than past generations, which might be regarded as unfair. Moreover, under the current cost sharing formula, the contributions of active members as well as their employers would rise to pay these deficit recovery contributions. Hence, current members would have to make a contribution in order to repair an underfunding of the pensions liabilities of past members. Again, this might be regarded as intergenerationally unfair.
There is the following problem with this objection to investment weighted towards growth assets: USS’s own approach to investment is at least as vulnerable to their objection of intergenerational unfairness.
USS’s preferred approach involves a lower level of investment in “growth assets”, both now and in the future, in order to make room for a higher and gradually increasing level of investment in bonds and other “liability-matching” assets. Given the liability-matching nature of the assets, it is less likely that a greater than expected deficit will arise in the future.
In order, however, to protect against such an unpleasant surprise, contributions must now rise for certain, beyond the level that previous generations of employers and members paid. This is because liability-matching assets are more costly than growth assets that provide equal expected returns. Moreover, on USS’s approach to investment, members in effect contribute, under the current cost sharing formula, to the recovery of the underfunding of past liabilities that exists from the outset.
So it’s six of one, half a dozen of the other, insofar as the intergenerational fairness of USS’s versus UCU and UUK’s approaches to investment are concerned.
Postscript on USS v. SAUL: Had USS invested as skilfully as SAUL has over the past 10 years, scheme members and employers would not now be faced with the above alternatives, each of which involves the risk or certainty of much higher contributions for current and future generations in comparison with past generations. Rather, it would have been possible to continue to provide DB pensions about as good as USS now provides, but at a much lower and more stable overall contribution rate (taking any deficit recovery contributions into account). In response to the question “How should USS invest its assets?”, I wouldn’t start from here, as the Irish joke goes. But here we are, given USS’s much less skilful investment over the past 10 years than SAUL’s, and it’s now too late and costly for USS to adopt SAUL’s superior approach.