Why USS lacks grounds for a reliance trigger
And why the trustee must prevent their executives from trying to impose one
If USS executives attempt to trigger an automatic rise in contributions in the event of a specified increase in ‘reliance’ (aka the ‘self-sufficiency deficit’) during the next three years, the trustee board must intervene and stop them. This is because the executive’s case for such a reliance trigger collapses in the light of their failure to account for their large and demonstrable mistake over Test 1. I explain why below.
I. The reliance gap
‘Reliance’ is the gap between the market value of the scheme’s actual asset portfolio and the market value of a gilts+0.75% ‘self-sufficiency’ portfolio that is >95% certain to cover the accrued DB liabilities. The gap is called ‘reliance’ because it is meant to be a measure of reliance on the ‘employer covenant’, the latter of which is the sponsoring employers’ ability to make up shortfalls in the funding of DB liabilities. Specifically, ‘reliance’ measures the cost of exchanging the current asset portfolio for a self-sufficiency portfolio that is more than 95% certain to fund the liabilities.
II. The size and volatility of this gap
Because the current portfolio is ‘broadly 60% equity-like, 40% bond-like’, whereas a self-sufficiency portfolio is heavily weighted towards index-linked gilts (see Appendix), the market values of the two portfolios are poorly correlated. As indicated by Figure 5 in the latest consultation document, during the last couple years, ‘reliance has swung by over £10bn from peak to trough: peaking at £26.6bn and falling as low as £16.6bn’ (p. 12).
As the graph indicates, in addition to being highly volatile, the reliance gap is also currently very large. It would now cost about £20 bn more to exchange the current c. £65 bn portfolio for a self-sufficiency portfolio. This is for the reason that, on account of the historically low gilt yield, the rate of return on a self-sufficiency portfolio is now very low, relative to the return on the actual assets in the scheme.
III. The gap as a trigger of higher contributions
It appears that USS would like to propose that, if the reliance gap rises above a certain level (e.g., >£25 bn) during the next three years, that would trigger an automatic rise in contributions above the ‘lower bookend’ level of 29.7%.
A 29.7% contribution rate is a relatively modest and affordable 3.7% increase above the current level of 26%. If that increase were split 65:35, employer contributions would go up by 2.4% and member contributions by 1.3% beyond their present level.
If that lower bookend had not been combined with triggers of higher contributions, it would probably have constituted the basis for an acceptable settlement between UUK and UCU.
If, however, such a lower bookend is combined with unreasonable triggers, it will become much more difficult to resolve the current dispute.
IV. Questions which the trustee must press if the executives try to impose a reliance trigger
For that reason, it is especially important that the trustee board carefully scrutinise any attempt on the part of USS executives to impose a reliance gap trigger. If their executives try to impose one, the trustees must press the following question (which I pressed in this linked blog from November 2017):
Why should it matter how expensive it might become to purchase a self-sufficiency portfolio during the next three years, given that it would make no sense to purchase one in the short-term?
Among other things, such purchase now would fly in the face of USS’s gilt yield reversion assumption, to which they appealed in September 2017 when they recommended a ten-year delay in the initiation of their planned shift in the portfolio towards bonds.
In their latest consultation document, the USS executives acknowledge that it would not make sense to purchase a self-sufficiency portfolio during the next three years, when they write that “we certainly do not expect to have to move to a self-sufficiency strategy in the short term” (p. 12).
So why should it matter how expensive it might become in the short term to do something USS acknowledges makes no sense at present?
Here is the answer the USS executives now provide:
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 the current risk position difficult to recover from — such that the ability to move to a self-sufficiency strategy in the long term moves out of reach. (p. 12, bold emphasis added)
In other words, USS executives are now claiming that, if the reliance gap becomes sufficiently large in the short term, that will render it too difficult to reach their long term target of a £10 bn gap by 2037 (i.e., the endpoint of the red dotted line in Figure 5 above).
V. The relevance of USS’s “large and demonstrable mistake” over Test 1
This, now, is where USS’s “large and demonstrable mistake” over Test 1 becomes relevant.
Sam Marsh’s asset projections, whose accuracy has been confirmed by USS, reveal that if USS were to remain invested in its current portfolio (60% equity-like, 40% bond-like) and it continued to charge the current 26% level of contributions to continue to accrue DB benefits at their current level, USS’s prudently adjusted (to a 67% chance of success) projection of expected returns is such that the reliance gap would be a mere £3 bn in 2037 — hence well within the target of £10 bn.
The scheme would also be expected to be in considerable c. £20 bn surplus, when measured on a prudent technical provisions basis, in 2037. USS’s “large and demonstrable mistake” was to assume that the expected level of assets would be the equivalent of full funding, with no surplus. Hence, they assumed that the prudently expected level of assets generated by the current portfolio would be about £20 bn less than indicated by their actual assumptions of prudently expected returns!
VI. USS’s rewriting of history to paper over their mistake
In this light of this mistake, the USS executives have now rewritten history and are providing a different account of Test 1 and its relation to the reliance gap. They now claim the following:
The realised reliance at 31 March 2017 was £22.4bn, and the 2017 valuation envisaged a target path over 20 years for reliance to fall to £10bn in real terms by 2037. (Note the target path is not the expected path, but merely a target against which progress can be measured.) (p. 12, bold emphasis added)
By pointing to past statements in which USS maintained that the target path is the expected path, here I document the manner in which USS executives have rewritten history:
Thread by @MikeOtsuka: " contradicts itself in its latest attempt to answer the critique arising…
Thread by @MikeOtsuka: " contradicts itself in its latest attempt to answer the critique arising from @Sam_Marsh101's…
VII. USS’s groundless refusal to allow the scheme to go into surplus
USS executives now maintain the following: Even though the current portfolio would prudently be expected to be in £20 bn surplus in 2037, and hence the reliance gap well within the £10 bn limit, their target path assumes precise full funding, with no surplus or deficit. Given this target of precise full funding, USS would take steps to eliminate any surplus that might arise. See this blog post, in which I discuss a statement of the above by Chief Risk Officer Guy Coughlan:
The rise in contributions traces to an inexplicable refusal to allow a surplus
USS’s response to my concerns over Test 1
There are at least two serious problems with Coughlan’s statement:
First, there is nothing in legislation that precludes the scheme from going into significant surplus. Such surplus is perfectly consistent, for example, with the ‘statutory funding objective’ of Section 222 of the Pensions Act 2004, which states that ‘Every scheme is subject to a requirement (“the statutory funding objective”) that it must have sufficient and appropriate assets to cover its technical provisions’.
Second, Coughlan provides no sensible actuarial justification for USS’s refusal to allow the scheme to go into significant surplus, as I explain here:
Given its lack of justification in legislation or actuarial theory, there remains only the following plausible explanation for USS’s adoption of a target of precise full funding: this is an attempt to paper over the “large and demonstrable mistake” in their application of Test 1.
VIII. Why USS’s rationale for a reliance trigger collapses
Once, moreover, USS abandons its unjustified refusal to allow the scheme to go into significant surplus, their latest rationale for a reliance trigger collapses. A short term rise in the gap to self-sufficiency beyond a given threshold provides little indication to USS that they must revise their expected returns on the assets currently held in the scheme, such that the portfolio is no longer prudently expected to generate sufficient returns by 2037 to ensure that the reliance gap remains within the prescribed £10 bn limit. USS provides proof of this claim in the valuation they have just issued. On their fundamental building block (FBB) model they use to construct expected returns on assets, updated to 31 March 2018 by new information gained during the past twelve months, the current portfolio continues to generate a sufficient surplus in 2037, thereby keeping things within the prescribed £10 bn reliance gap. This in spite of the recent volatility and size of that gap.
For that reason among others, the only things that might justifiably trigger an increase in contributions before the next valuation are events so major as to justify a significant downward revision in expected returns, on USS’s FBB model. The rest — both the volatility in the reliance gap and fluctuations in the gilt yield which drive USS’s current monitoring deficit — is financial noise which cannot form the rational basis for a trigger of higher contributions.
The trustee must mind their executives. They must not permit them to mind the reliance gap in the mindless fashion that is now being contemplated. This is their fiduciary responsibility.