Problems with USS’s measures of short-term and long-term risk

Two questions to USS for their video on the 2020 valuation

In response to this invitation, I would like to submit two questions to which I hope USS will provide replies in a video they release on Thursday the 9th of April. The first question is about USS’s measure of short-term risk and the second about their measure of long-term risk:

Q1. Why should it matter how expensive it might become to purchase a self-sufficiency portfolio within a year, given that it would make no sense to purchase one so soon even if it were possible to shift the assets so swiftly?

Q2. What is USS’s justification for measuring the self-sufficiency deficit in 20 years’ time on the assumption that the scheme will be precisely 100% funded at that time (i.e., assets = technical provisions), rather than in any surplus that is regarded as 67% likely — where 67% reflects the level of prudence, above and beyond a 50% best estimate, that USS builds into their expected returns on assets in setting the discount rate for the technical provisions?

Background

UCU and UUK are now both unconvinced by the case USS has made for reducing the portfolio’s current 65% level of investment in growth assets (equities and property). USS would, however, like to shift away from growth assets and into greater investment in bonds on grounds that both the short-term and the long-term risks of remaining so heavily invested in growth assets are too great.

USS’s measure of short-term risk is the gap between (1a) the current value of the assets and (1b) the higher cost of now purchasing a gilts+0.75% self-sufficiency portfolio plus (2) the increase in this gap over the next year that has a 1 in 20 chance of arising in a worse case scenario.

If this measure exceeds the “risk appetite” of employers by too great a margin, USS deems short term risk too high and maintains that steps must be taken in response.

USS defines the employers’ “risk appetite” as the value of the extra contributions employers would be willing to make over a set number of years in an adverse scenario, in order to eventually raise enough money to purchase a self-sufficiency portfolio by the end of that time period. USS works from the assumption of a risk appetite of +10% contributions over 30 years, the present value of which is £35bn. But…

Q1. Why should it matter how expensive it might become to purchase a self-sufficiency portfolio within a year, given that it would make no sense to purchase one so soon even if it were possible to shift the assets so swiftly?

In their January 2019 consultation document on the 2018 valuation, USS acknowledged that it would not make sense to purchase a self-sufficiency portfolio so soon, when they wrote that “we certainly do not expect to have to move to a self-sufficiency strategy in the short term” (p. 12). So why should it matter how expensive it might become in the short term to do something USS acknowledges to make no sense at present?

Here is the answer USS executives provided in January 2019:

While we certainly do not expect to have to move to a self-sufficiency strategy in the short term, there are credible scenarios that could make the current risk position difficult to recover from — such that the ability to move to a self-sufficiency strategy in the long term moves out of reach. (p. 12, bold emphasis added)

In other words, USS executives maintained that if the gap to self-sufficiency becomes too large in the short term, that will provide an indication that it would be too difficult to move to a self-sufficiency portfolio at a distant future date when, unlike the present or near future, it might make sense to move to such a portfolio.

That brings me to my second question, regarding USS’s measure of long-term risk:

Q2. What is USS’s justification for measuring the self-sufficiency deficit in 20 years’ time on the assumption that the scheme will be precisely 100% funded at that time (i.e., assets = technical provisions), rather than in any surplus that is regarded as 67% likely — where 67% reflects the level of prudence, above and beyond a 50% best estimate, that USS builds into their expected returns on assets in setting the discount rate for the technical provisions?

For problems with the justifications for this assumption that USS has provided in the past, see my blog post entitled “The rise in contributions traces to an inexplicable refusal to allow a surplus: USS’s response to my concerns over Test 1”, plus the earlier posts and later Twitter threads to which I link in that blog post.

Written by

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

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