Joseph Mariathasan: USS debate raises profound questions for UK DB
The Centre for the Study of Financial Innovation (CSFI) held a roundtable last week on the issues of pension funding raised by the USS debate, with protagonists from two schools of thought regarding pension liability valuations.On one side were those who believe that pension liabilities are akin to bonds and can be valued as such, while the other side believes that cashflows, not present value calculations, are what should drive investment policy. Credit: Warwick University UCU branch UCU members striking at Warwick University over USS proposals earlier this yearThe debate – if it can be called that – was a great disappointment. The two sides have fundamentally different philosophical frameworks for defining the valuation and hence the management of defined benefit (DB) pension schemes and no amount of arguments are likely to create a consensus, any more so than the creation of a ‘consensus theology’ could have arisen from the religious wars of the past.Religious wars were ultimately settled by an acceptance of the freedom to worship as one wishes. That option is not available for the protagonists in the debate over pension valuations.The one thing both sides can agree upon is that the crisis surrounding USS is due to failures in the system of pension regulation and control rather than in the management of USS itself. That raises the point that, quite apart from the ‘theological’ arguments over valuations, the more important question is whether and how DB schemes can remain in existence. That issue, along with issues such as finding other providers of risk capital for the UK economy, are still to be resolved .The writing on the wall for DB pensions came when what used to be regarded as promises to pay pensions on a ‘best efforts’ basis became legal liabilities. Managing a DB pension scheme thus became a risk management problem, not an investment one, so eliminating all investment risks irrespective of the costs trumps any other objective.For many individuals with DB pensions, that has provided extremely attractive transfer values – in many cases, members have been offered 40 times their annual pension when considering transferring out, as a result of the yields on gilts and index-linked gilts falling to low levels as pension funds have bought them up to match liabilities.Perhaps the most important product of the JEP’s report was that the second phase of its work should seek to determine whether there is an alternative methodology for future valuations that could provide long-term stability for USS while enjoying the support of all parties.Where does this leave USS ? Guy Coughlan, chief risk officer, points out that the real issue is not whether USS has a current surplus or deficit in terms of accrued obligations, but whether contribution rates will be sufficient to generate the income for the fund to provide for the continued accrual of new pension benefits in a world of lower returns. It is this issue, he argues, that is the real driver behind the recommendation to increase contribution rates.It is difficult to see how the JEP by itself can solve the underlying issue of the high cost of guaranteed annuities that lies behind the demand for higher contributions. The panel may be able to postpone any drastic decisions for a few more years, and it is conceivable that market conditions could change for the better with regard to prospective asset returns.Given the importance of the higher education sector, however, there may be a case for future governments to consider alternative options, which could range from granting a state-backed guarantee, to measures enabling more risk-taking.At the extreme, the government could even take on historic liabilities as it did with the Royal Mail Pension Plan a decade ago, absorbing assets to help pay down the national debt and pay pensions to academics out of general taxation, as is currently the case with civil servants.Ultimately, pensions are just one element of the total compensation package offered to academic staff. What they should be and how they should be delivered cannot be separated from a more general discussion on how academic staff should be paid in order to attract and retain talent in a critical sector for the UK. The first report of the Joint Expert Panel (JEP) on the valuation of the Universities Superannuation Scheme (USS) was published on 13 September. This should keep academics happy for a while and gives the management of USS a clear direction on which way to head.However, while this provides a compromise of sorts, the underlying issues that gave rise to the passionate debate and industrial action have not actually gone away.As expected, the JEP has come out with a set of recommendations that should enable the future contributions rates to be set at levels significantly lower than originally proposed. It has done this through a series of tweaks to the investment assumptions used by USS enabling the JEP to recommend reduced contribution levels.The key changes they have put forward involve re-evaluating sponsors’ attitudes to risk and the reliance on the sponsor covenant; adopting a greater consistency of approach between the 2014 and 2017 valuations, which affects the scale and timing of deficit recovery contributions; smoothing future service contributions to ensure greater fairness between generations of scheme members; and using more current information, including recent market improvements, new investment considerations and the latest data on mortality.