USS failed to make clear the high level of prudence of the September valuation

New doubts over consultation, as USS did not explain, and employers did not understand, that protection against gilt yield risk was already built in

If employers had accepted the level of risk that USS proposed in September 2017, Test 1 would have been satisfied even in the absence of any cuts to defined benefit pensions or increases in contributions. This is because USS data and forecasts implied a 67% chance that the assets in the fund would reach a level of £117.9 bn or higher by the year 2037 in such a scenario. Yet Test 1 required a 67% chance that the assets reach only a lower level of £112.5 by then. These conclusions are based on the analysis of USS data that Sam Marsh, who is a union-appointed member of USS’s Joint Negotiating Committee, has recently posted on the internet.

In their September consultation document, however, USS claimed that it would be possible to maintain benefits at their current level only if contributions increased by 6.6% — to 32.6% from their current level of 26%.

What explains the above discrepancy? The answer appears to be contained in this passage from First Actuarial’s submission to the September consultation:

In carrying out our projections, we have identified an important feature of the development of the future service rate [i.e., the contributions required for future DB accrual] over time.

It is notable that for the first 10 years, the discount rate is negative
in real terms. A material market value fall is implied. This has consequences for the future service rate. As time passes and the first 10 years’ negative real return drops out from the discounting, the cost placed on future benefit accrual reduces….

We estimate [that the rate of future service in 2018 is 27.2%].

Adding 3.3% for DC contributions and expenses and 2.1% for deficit contributions gives a total contribution rate of 32.6% in the first year of the valuation [i.e., 6.6% higher than the current 26% contribution rate].

[But the] future service rate is scheduled to decline by 5.3% of pensionable pay over 10 years….

We cannot detect whether this progressive reduction in the future service rate is recognised in the consultation document. It appears to us that the rate for year ending 2018 is assumed to apply for all time, which it does not. [emphasis added]

In assuming payment of 27.2% for future service “for all time”, rather than a rate that reduced by 5.3% over 10 years and then settled in at a lower equilibrium rate of 21.9% for subsequent decades, USS arrived at the high figure of 32.6% that employers and scheme members would be required to pay as a regular increase in contributions in order to maintain the status quo while also satisfying Test 1.

In their response to First Actuarial dated 17 November, USS eventually confirmed this:

First Actuarial note that:

“We cannot detect whether this progressive reduction in the future service rate is recognised in the consultation document. It appears to us that the rate for year ending 2018 is assumed to apply for all time, which it does not.”

The future service rate would, if the Trustee’s central assumptions are borne out in practice, reduce at future valuation dates. The Trustee’s central view is that long term interest rates will rise faster than markets currently allow for in their pricing of long dated gilts. The Trustee believes that the price set should reflect the prevailing conditions at the valuation date. Underpayment of contributions towards the cost of future accrual in the early years in the expectation that this will average out in later years is not acceptable to the Trustee as it adds to the gap between assets and the build-up of benefits in the shorter-term at a time when all efforts need to be aligned to reduce that.

This explanation is of special significance to the September employer consultation for the following reason: USS’s projected fall in the rate of contributions for future service was directly linked to their assumption that the gilt yield would revert by +1.5% above market forecasts over the next 10 years before reaching an equilibrium. This reversion is the “material market value fall” to which First Actuarial refers in the quoted passage above. Here USS appears to have taken on board a fairly widely held view that the price of UK gilts will fall to a greater extent than long dated gilt yields now indicate, once the Bank of England’s policy of quantitative easing is unwound in coming years.

As First Actuarial notes, however, this fact about the decline in the rate of future service contributions and its relation to the gilt yield was not made clear in the September consultation document itself. I am also informed that, during the consultation, at least one employer asked USS to please confirm or deny First Actuarial’s analysis regarding the decline in the rate of future service contributions. USS was not forthcoming with a response at the time.

This lack of transparency is significant for the following reason.

In their collective response to the consultation, Universities UK raised concerns about USS’s assumed reversion in the gilt yield beyond market forecasts. As USS reported:

In particular, 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.

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.

As a result, the board agreed a revised future average annual returns forecast of CPI + 0.71%, resulting in a funding deficit of £7.5bn (89% funded). Maintaining the current level of benefits would, in turn, require a combined contribution rate of 37.4% of pay, including increasing deficit recovery contributions from 2.1% of pay currently to 6%.

Rather than implementing the employer’s suggestion to change their investment strategy in order to hedge against the possibility that the gilt yield would not revert as they had predicted, USS should instead have done the following. They should have clearly explained, both in the original consultation document and in their response to the employer consultation, that this possibility of non-reversion was already covered by the 6.6% rise in regular contributions they were proposing. In the event that the gilt yield did not rise as anticipated, regular contributions would remain at this elevated level, though they would reduce at later valuations in the event that USS’s forecast turned out to be correct. Protection against the inaccuracy of their forecast was therefore already built into the 6.6% increase.

Had employers been made aware of this fact, that would have addressed their concerns over the risks of the gilt yield not reverting as USS had predicted. It may also have forestalled their attempt to protect against this risk by suggesting changes to USS’s investment strategy, which then prompted USS to speed up the de-risking of the assets in the scheme, thereby raising the level of contributions required to preserve the DB status quo even higher.

Such de-risking is a continuation of a path on which USS has been travelling these past ten years, which has rendered defined benefit pensions increasingly unaffordable and difficult to sustain.