USS must be planning for the possibility of DB scheme closure in 20 rather than 40 years

In a blog post entitled ‘Beyond 40 years here be dragons’, I reported that, at a meeting with USS executives in March 2018, “they informed me that the rationale for Test 1 was to ensure that it is possible to close the DB scheme, within 40 years, with no further contributions needed to be made into the scheme beyond that point”.

In the last two paragraphs of this briefing note written by their Chief Risk Officer Guy Coughlan in November 2018, USS appears to confirm my understanding of their views. Coughlan writes:

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 our current risk position difficult to recover from — such that our ability to move to a self-sufficiency strategy in the long term moves out of reach.

To quote your blog ‘Beyond 40 years, here be dragons’: “USS has emphasised that closure in 40 years’ time is not a target or a goal. It’s just something that will have to be possible to achieve by then, given lack of visibility of the covenant beyond that point. That is not an unreasonable basis on which to manage the scheme.”

For the following reasons, I now believe that USS must be assuming DB scheme closure within 20 rather than 40 years.

In advance of my March 2018 meeting, USS provided me with this linked modelling in response to a question I had posed regarding Test 1.

The modelling indicates scheme closure in 2017. My understanding from discussion at the meeting was that they were modelling 2017 as if it were 40 years from then (2057), at which point the scheme closes and goes into run-off.

I now believe, however, that this must have been a misunderstanding.

Having re-examined and reflected on its assumptions, I can’t make sense of their modelling on the assumption that 2017 is 40 years hence. I can make sense of it only on the assumption that 2017 is 20 years hence.

More precisely, I now think this is what USS’s modelling (and therefore Test 1) must be assuming: that it be possible to close the DB scheme by year 20 and fund the accrued liabilities of this closed scheme entirely out of a self-sufficiency portfolio by year 40, with no need for further employer contributions after year 40. During years 20–40, the DB scheme would be closed to future accrual but not funded by a self-sufficiency portfolio. Rather it would be funded by a portfolio which conforms to the requirement of Test 1 in year 20, and which is gradually transformed into a self-sufficiency portfolio via +7% employer contributions during years 20–40.

The first two pages of USS’s March 2018 response to me provide useful information about their assumptions regarding length of covenant and last man standing. USS maintains that regulatory requirements do not permit them to assume that the scheme will remain open indefinitely. Rather, given the merely finite length of the covenant they’ve established — confidence in strength over at least 20 year, less confident belief in strength during years 20–30, horizon becoming progressively more hazy during years 30–40, and beyond year 40, things go dark— USS appears to be claiming (on my current, updated understanding of what’s going on) that the regulations require a valuation that assumes possibility of DB scheme closure by year 20 and the funding of such a closed scheme entirely out of a self-sufficiency portfolio by year 40.

There is the further reason to think USS must be assuming scheme closure by year 20: if the scheme carried on accruing DB liabilities during years 20–40, Test 1 would provide no assurance that these promises could be kept, since its safe harbour covers only liabilities accrued up to year 20. In the absence of being able to back up year 20–40 liabilities by the Test 1 safe harbour, it would be inexplicable if the scheme were assumed to carry on accruing these liabilities at a time when the horizon is becoming increasingly hazy and the assumption that it is strong increasingly difficult to justify.

I note in conclusion that, even on my revised understanding of the timescale of scheme closure that Test 1 assumes, it remains the case that Sam Marsh’s asset projections show that USS made a large and demonstrable mistake in concluding that Test 1 justifies any shift out of return-seeking assets and into bonds during the next 20 years.