USS’s much-debated Test 1 calls for a “de-risking” of the growth assets now held in the pension scheme to a lower level of growth, from which it will be possible to de-risk the scheme even further, all the way down to the level of “self-sufficiency”. A “self-sufficiency” portfolio is defined as one that comes close to guaranteeing full funding of promised pensions without the need for additional contributions beyond those already made. It resembles the low-growth assets held by an insurance company for the provision of annuities.
According to USS, the purpose of Test 1 is to make it possible to finance such a self-sufficiency portfolio within an affordable level of increase in employer contributions. The maximum affordable increase is assumed to be 7%, which is the difference between the current 18% employer contribution and a 25% contribution, the latter of which is deemed the upper limit of affordability.
But this 7% limit ignores the fact that, in addition to raising their contributions above 18%, employers can and will tap into their contributions below 18%. They will do so by cutting back on future accrual of DB pensions, as they did in the aftermaths of the past two valuations. So the focus on the 7% difference between 18% and 25% is unjustified, as UUK notes in their December 2014 submission to the last valuation:
There is a strong focus on the gap between 25% and 18%. Both of these parameters could be explored further. In particular, if the trustee was required to increase the funding target to a self-sufficiency level, then this may come at a time when further benefit changes were justified, meaning that a proportion of the 18% employer contributions could be funnelled into making up the gap to self-sufficiency. (p. 2)
As the postscript below explains, the test also creates a slippery slope that leads inexorably from DB to DC.
PS: In an earlier version of the post below, I wrote that DB trustees have “a duty to make sure that DB pensions already promised will be paid”, but that it “is outside of their remit to concern themselves with the level of DB pensions that will accrue in the future”. In a public Facebook comment thread on this post, First Actuarial’s Derek Benstead expressed a contrary view:
This is a common opinion in the pensions industry, one which is promoted by the Pensions Regulator. However, I don’t agree with it. It is the job of the trustees to deliver the benefits defined in the trust deed, which includes the benefits which can be earned during future service.
He then went on to raise the following powerful objection to self-sufficiency-based standards such as Test 1, which points to the manner in which their application leads to the replacement of DB with demonstrably inferior DC pensions:
It is perverse for defined benefit scheme trustees to make their scheme certain to be more expensive by investment in assets of low return, which encourages the sponsoring employer to terminate the DB scheme and replace it with a DC scheme, where the contributions to the DC scheme are limited by the high cost of deficit contributions to the DB scheme. The outcome for members is a lower total pension at retirement and a less certain pension at retirement, because the new DC scheme receives lower contributions and because a DC scheme is less cost efficient than a (sensibly invested) DB scheme, so a given contribution achieves less in a DC scheme.
I find it hard to see why DB trustees should pat themselves on the back for making their members’ accrued pensions more secure, when their members pension expectation at retirement has become much lower and much less certain due to the switch to DC which the trustees’ actions triggered.
We see the above perverse dynamic playing itself out in the way in which Test 1 is causing the demise of USS’s DB pension and its replacement with less well funded and otherwise inferior DC pension pots. I hope USS officials and trustees, and university employers, who embrace Test 1 will reconsider their commitment to it in the light of his comment.
(This post is a follow-up to this linked post which provides a background explanation of Test 1 and the accompanying notion of self-sufficiency plus an explanation of First Actuarial’s critique of USS’s approach.)