Most of the critics of USS’s Test 1 maintain that it is overly prudent in setting too demanding a level of aversion to risk. In his submission to the Joint Expert Panel, however, David Miles of Imperial College raises the opposite worry
that passing Test 1 should give members of the USS and the sponsoring universities little comfort. To put it another way: the position of the scheme is more precarious than the apparently ultra-prudent USS calculations suggest.
In this post, I explain why Test 1 remains sufficiently prudent.
The underlying objective of Test 1 is 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.[*] At that point, pensions benefits would be paid out of a low-risk ‘self-sufficiency’ portfolio weighted towards bonds, which has a 95%-97.5% chance of being able to cover all DB promises that have accrued.
David Miles raises the following objection [**]:
‘self-sufficiency’ means only that pensions can be paid, without extra support, with ‘a high degree of confidence’. How high is that? This is not entirely clear from the documents USS make easily available, but I believe the answer is with a probability of 95%. That would be considered scandalously risky for a bank and completely unacceptable to bank regulators. I suspect that USS scheme members would not consider the scheme to be on a solid foundation if they got their promised pensions 19 times out of 20.
This fear that ‘self-sufficiency’ leaves members with a 5% chance of failing to receive their promised pensions is unfounded. It rests on the implausible assumption that there will be no UK higher education sector around more than 40 years from now, whose employers will be able to make at least modest deficit recovery contributions in the 5% likely event that the self-sufficiency portfolio underperforms. Given the low variance in the value of assets in a low-risk self-sufficiency portfolio, any deficit from which it might be necessary to recover is unlikely to be very large.
Although we can safely set the above worry to one side, there remains the following further challenge to which Test 1 gives rise, to which I shall devote the remainder of this post.
Test 1 requires that it be possible to purchase a self-sufficiency portfolio by year 40, via a supplementation of the scheme’s assets through an increase of 7% — i.e., from the current 18% to the maximum affordable 25% of salaries — in employer contributions from years 20 to 40.[*] The assets must reach a market value by year 20 that is sufficiently high that it is possible to get from there to self-sufficiency via such an increase.
Insofar as this possibility of getting from year 20 to year 40 is concerned, it does not matter whether the mixture of assets in the scheme at year 20 remains along current lines — namely “broadly half in equities, one-third in bonds and the balance in infrastructure, property and other assets” — or whether the assets have been ‘de-risked’ in the manner USS now proposes, via a 20 year shift towards bonds. Rather, what matters is the market value, not the composition, of the assets at year 20.
The challenge is that it must now be possible, in year 1, to ensure that the value of the assets reaches the required level by year 20.
On the assumptions USS uses for Test 1, there is, however, only a 67% chance that the assets will reach the required level by year 20. It follows, of course, that there is a 33% chance that the assets will fall short of this level, in which case it will not be possible to purchase a self-sufficiency portfolio by year 40.
Therefore, assurance must be provided that it will be possible to recover from the 33% of scenarios in which the value of the assets falls short of the required level by year 20. This recovery would need to come out of extra deficit recovery contributions beyond the current 18% regular employer contributions. All of these extra contributions would need to be paid before year 20. This is because Test 1 assumes that, from years 20 to 40, the maximum affordable 25% (18%+7%) is going towards raising the required funds to purchase a self-sufficiency portfolio by year 40.
USS might appeal to the need to provide this assurance in order to try to justify their plan to ‘de-risk’ the portfolio through a shift to bonds between now and year 20. They might maintain that the current growth-weighted portfolio carries too much downside risk for it to be possible to guarantee that the scheme could recover from losses, via extra deficit recovery contributions between now and year 20, and reach the required asset level by year 20.
In any event, some such explanation is needed, for why we cannot remain continually invested in the current growth portfolio between now and year 20.
Such an explanation is needed, in light of the fact that we now have a long 20 year period in which to make adjustments out of extra deficit recovery contributions to get to the required level of assets by year 20. As one gets closer and closer to year 20, there will be less scope for making the needed adjustments to recover from unexpected falls in the value of the assets. If, however, the covenant remains as least as strong and visibly long from triennial valuation to triennial valuation, the relevant target date will always remain 17–20 years in the future, as the 40 year horizon and its 20 year midpoint will always move forward in time by 3 years at each valuation.
If the strength and visible length of the covenant deteriorate at future triennial valuations, then one might need to revise Test 1 in a more conservative direction at that point. But there is not now any call for such revision.
[UPDATE 10 February 2019: [*] This sentence has been revised in the light of my updated understanding of the length of the horizon that is assumed by Test 1. See ‘USS must be planning for the possibility of DB scheme closure in 20 rather than 40 years’.]
[*] Miles also raises other challenges for USS in his submission, which I do not address in this post. In particular, he questions the credibility of USS’s claim that there is a 67% chance of achieving full funding. He does not, however, raise the particular challenge to Test 1 to which I have devoted most of this post.