25 October 2013
- Universities Pension Scheme scaremongering is overdone
- Classic example of damage to pensions from QE
- USS is not a closed scheme, so it is unfair to compare it with most other UK schemes
- Its funding position is being well managed and it should not be panicked by exceptional interest rate environment
USS scare stories overdone: Scare stories today about the black hole in the USS Pension Fund (Universities Superannuation Scheme) are overly negative. This huge pension scheme, with 300,000 members, of whom around half are contributing regularly to the fund, has performed well in recent times and, because it is still taking in contributions, its time horizon and investment approach will be different from that of the majority of UK final salary schemes which are now closed. Large deficit numbers must be seen in proportion to the very large size of the scheme itself. Also, the deficit has been driven by historically low gilt yields, influenced by QE, which significantly inflates the reported current value of long-dated liabilities.
Has not been sitting on its hands: USS has been dealing with a legacy deficit for a number of years and has not been sitting on its hands. It has had ongoing reviews and has increased contribution levels, reduced benefits and also changed its investment approach to reduce risk relative to the liabilities.
Discount rate for liabilities is reasonable: The calculations that suggest the USS deficit is really much larger than reported are based on applying a discount rate used for accounting purposes which is lower than the rate used by the scheme itself for funding purposes. The USS return assumption is based on gilts + 1.7%, which is not an unreasonable assumption and will allow it to recover its deficit over time. Assuming a lower discount rate is not necessarily justified and only serves to make the deficit look much larger.
Not right to compare USS with closed mature schemes backed by just one employer: The USS scheme is open and backed by a large number of employers, which is very different from a closed scheme which is backed by just one company. USS has 390 employers contributing, who are currently putting in 16% of each worker’s salary. This is very different from a mature scheme, backed by one weak employer. This means that it can take a much longer-term approach to investment and should not be measured by a discount rate which assumes more bond-like investments with much lower returns over time. If the scheme were mature and had a weak sponsor covenant, that might be more appropriate, but USS is not in that position, so artificially calculating over-pessimistic liability values is not suitable.
Difficult balancing act to keep focus on the long-term in post-QE interest rate environment: USS investment performance has been strong and it will be cash flow positive for the foreseeable future, so it is collecting in more from contributions than it is paying out in pensions. This requires a long-term investment approach. Especially as interest rates have been artificially depressed by short-term policy decisions and official buying of gilts by the Bank of England under Quantitative Easing, it would not be appropriate for this long-term pension scheme to be too heavily focused on liability measures that are likely to be distorted in the short-term
USS is investing for the long-term: As it should, USS is already investing to take advantage of illiquidity risk premia, it has cut its exposure to equities but in favour of other assets such as infrastructure which can directly benefit the UK economy, as well as delivering good longer-term returns. It has sensibly steered away from just switching to gilts at current levels, but it is investing in other bonds and ensuring a diversified long-term portfolio which is performing very well.
Assets performing strongly: The USS scheme has performed strongly – rising by over 13% in the past financial year. Unfortunately, because of interest rate changes, the mark to market valuation of its liabilities has risen by more than this, however the volatility of interest rates in the short-term should not driving long-term strategy.
USS management is acting to readjust over time, but don’t want knee-jerk reactions: There is an ongoing assessment exercise being conducted by the managers of USS which is taking its responsibilities seriously and has already seen a process of readjustment in recent years. In 2011, the final salary scheme was moved to a career average scheme for new members and employer contributions were increased. This process will continue, as it should, but there should not be knee-jerk reactions to short-term market factors. Pensions are a long-term business.
Contributions may have to rise but that must be negotiated: In 2011, the trustees and employers agreed increased contribution levels. Employers are currently paying 16% of salary, while members are paying around 7.5% (or 6.5% in the career average section). It is likely that these contribution levels will need to increase further after the next valuation and there may also need to be some further adjustment to benefit levels, but this is all set to be negotiated on the basis of long-term forecasts.
State Pension Reform will also have an impact as contracting out ends – will mean higher NI but lower liabilities: As a result of state pension reforms proposed for 2016, the contribution levels for members and employers with defined benefit pension schemes are set to rise. Until now, members and employers have been paying lower national insurance to reflect the fact that the pension scheme replaces the earnings related element of state pensions, this is called ‘contracting out’. The ‘contracting out rebates’ for these scheme members seem set to end in April 2016, so employees will see a rise of 1.4% in their National Insurance contributions and employers will face around a 3.4% higher contribution level on a portion of their earnings. To offset this, the pension scheme will no longer have to replace the earnings-related part of state pensions which should also mean the costs of its future liabilities will fall as the benefit structure changes.
USS benefits hugely valuable: The benefits provided by the USS pension schemes are hugely valuable and those in charge of the scheme are managing it responsibly as far as I can see. They are right not to be frightened by short-term factors and the benefits provided include such additional elements as critical illness and life insurance cover, as well as automatic inflation increases and partner’s pension. New-style defined contribution schemes do not provide such valuable extras and clearly this is a benefit that employees will appreciate and may need to pay extra for in future – time will tell.
Wrong to suggest student fees will need to rise to cover pension shortfall: The scare stories about student fees rising from current levels to cover pension shortfalls are inappropriate. The universities which sponsor the USS pension scheme are strong and have a range of ways in which to tackle the deficit in future if needed. The USS management have said they are undertaking ongoing reviews of appropriate funding levels and tying together the strength of the sponsors with the investment strategy and actuarial assumptions. The extreme volatility of interest rates recently has made this task much more difficult, but also enhances the case for considering such matters with a longer-term time horizon, rather than being bound by short-term factors.
USS should not be assessed like other schemes: An open, industry-wide pension fund such as USS needs to be managed differently from the majority of closed schemes, it has assets that can help the UK economy directly, as well as providing long-term pension benefits for hundreds of thousands of members. Applying approaches that fit closed, mature schemes with just one sponsor is not appropriate.
Dr. Ros Altmann