“Universities accept a small amount of increased risk”
In a meeting with Universities UK (UUK) employers on Tuesday 27 February, the University and College Union (UCU) proposed that “Universities accept a small amount of increased risk through a return to the risk level USS proposed in September 2017 —something the majority of institutions were happy with”.
Why did the Universities Superannuation Scheme (USS) move away in the first place from the level of risk they proposed in September to the lower level they approved in their revised November valuation? USS writes that this is because in their response to the September consultation:
UUK raised concerns about the challenges that would be faced if interest rates were not to revert at the pace and within the timeframe anticipated in the assumptions. It asked the trustee to consider whether the proposed investment strategy (including the degree of interest rate hedging) was optimal for the level for risk being run and the targeted level of returns.
USS responded to these concerns by revising their approach to risk as follows:
We had originally proposed putting on hold the strategy agreed in 2014 to reduce the investment risk for a period of 10 years whilst long term interest rates revert to more “normal” levels.
UUK’s responses indicated to us that we should take a more moderate approach to risk. The trustee board accordingly agreed to retain the 2014 approach to de-risk the scheme’s investments over the next 20 years. In practice, over time, this means holding slightly fewer growth-seeking assets and more fixed income assets, which in turn results in a marginally lower income from investments to fund the current level of benefits and recover the funding deficit.
In short, in September USS had proposed to delay, for 10 years, the start of a shift of the assets in the portfolio over the next 20 years from growth assets towards bonds. In response to employer concerns, however, USS decided in November to begin the shift immediately. In slide 5 of a presentation to Imperial College, USS provides graphic illustration of what such ‘Early De-Risking’ would involve.
The reversion to the September level of risk that UCU is calling for would therefore amount to a retention, for the next ten years, of the current growth portfolio, which USS characterizes as “broadly half in equities, one-third in bonds and the balance in infrastructure, property and other assets.” After that point, the shift towards bonds would commence. This 10 year delay is illustrated by the September ‘Consultation De-risking’ graph on slide 4.
In what follows, I offer three grounds for employers to agree to revert from the ‘Early De-risking’ of the revised November valuation to the 10 year delayed ‘Consultation De-risking’ of the original September proposal:
I. Very little would be lost, in terms of protection against risk, by a 10 year delay in the onset of de-risking
Slides 6–8 of the presentation to Imperial illustrate the gains, in terms of protection against risk, of ‘Early De-Risking’ as compared with ‘No De-risking’, where the latter involves the complete cancellation of the shift from growth assets towards bonds, rather than the delay of the onset of this shift for 10 years. Such complete cancellation is the preferred approach of UCU’s actuary. This option is not currently on the table. It is nevertheless useful to compare ‘Early De-Risking’ with ‘No De-Risking’ in order to get a sense of the protection against risk which would be lost from UCU’s proposed shift from ‘Early De-Risking’ to the 10 year delay in de-risking of the September ‘Consultation De-Risking’ proposal.
What is striking is that slides 6–8 reveal the modest nature of the protection against risk that would be lost from the more dramatic shift (not on the table) from ‘Early De-risking’ to ‘No De-Risking’. Slide 6 reveals a very small difference, in terms of protection against downside risk that has a one in three chance of occurring, when we compare ‘Early De-Risking’ with ‘No De-Risking’. The following two slides 7 and 8 reveal very modest differences in terms of protection against a worst case scenario that has only a 1% chance of occurring. They also reveal a modest difference in ‘Deficit Volatility’, which is a measure of the volatility in the gap to self-sufficiency. (Please read this post on the nature and significance of this gap.) Here is slide 8:
It is safe to assume that the loss in protection against risk from the reversion from November ‘Early De-risking’ back to the 10 year delayed de-risking of the September Consultation would be much more modest than the already modest losses mentioned above of the more dramatic contrast between ‘Early De-risking’ and ‘No De-risking’. Perhaps that is why USS does not offer a graphic comparison of ‘Early De-risking’ with ‘Consultation De-risking’. They might prefer that we not see how little is gained, in terms of protection against risk, by the speeding up of the shift to bonds!
USS maintains that the speeding up of this shift gives rise to only “a marginally lower income from investments to fund the current level of benefits and recover the funding deficit”: i.e., a reduction in the discount rate from CPI + 0.9 to CPI + 0.71. However modest this may appear, it is, however, the difference between the affordability and the unaffordability of UCU’s current proposal. [CORRECTION 1 April 2018: Apart from the de-risking of the portfolio, there is, however, another aspect of the move from the September to the November valuation, involving the level of short-term risk. UUK’s failure to address this risk to USS’s satisfaction led to an increase in deficit recovery contributions, which accounts for most of the difference in the cost of providing DB pensions between September and November. See answer to Q2 of this blog post.]
II. A 10 year delay in the onset of de-risking would protect against a scenario in which USS is right in their forecast of the gilt yield reversion
The speeding up of the shift to bonds, via ‘Early De-risking’, is supposed to protect against the possibility that the gilt yield does not revert to 2014 levels more quickly than markets forecast. If, however, USS is actually right that the gilt yield will revert more quickly, then speeding up the shift to bonds will be counterproductive, since gilt yield reversion involves a significant fall in the asset price of gilts within ten years. USS anticipates that, once the demand for gilts induced by quantitative easing ends, the price of gilts will fall (and therefore the yield on gilts will rise) more quickly than markets are forecasting. Hence, if USS shifts to bonds now, it will be buying assets before the bursting of a bubble that USS is forecasting. That is why USS proposed in September to delay the onset of de-risking:
Based on the trustee’s view of interest rate reversion, the economically optimal course of action would be not to de-risk until year 11– consistent with its best estimate view that gilt yields will revert to broadly 2014 levels over the first 10 years. Under this approach, steps to reduce risk exposure by investing in lower risk portfolios will then be taken from year 11 in order to arrive at the targeted level of reliance of £10bn by year 20. [p. 9]
III. A 10 year delay in the onset of de-risking is precisely what UUK’s actuary argued for in 2014
Early de-risking is contrary to UUK’s own recommendation in their response to the 2014 consultation (see p. 5), when, on Aon’s advice, they actually called for a 10 year delay in the start of this shift, which USS rejected back then.