2020 valuation

Fundamentally, the original reasons for holding a 2020 valuation still hold: we had committed in advance to hold a 2020 valuation, and a number of the funding metrics we monitor were in the red at 31 March 2020. Carrying out a valuation was a measured response to that situation.

Market conditions at 31 March 2020 were not universally negative for the valuation: asset prices crashed, which affected the deficit in respect of pensions already promised to USS members – but lower market prices meant the outlook for future investment returns was unusually high. Higher expected future investment returns help to lower the contributions required to fund USS pensions.

We have compensated for this in prudent discount rates and in the proposed deficit recovery plan. These adjustments have been validated at 31 March 2021: asset prices had recovered (which we have allowed for in the indicative deficit recovery plan) and, partly as a consequence, the outlook for future investment returns was lower (which we allowed for in the discount rates).

- Our colleague Mirko Cardinale looks at these changing conditions in his analysis.

That’s one reason why we do not believe a 2021 valuation would deliver a materially different outcome. For more, read our briefing note.

The original reasons for holding a 2020 valuation still hold. Our primary legal duty as trustee is to protect the benefits promised to, or accrued by, USS members to date. Active members are accruing new benefits every day, so any underfunding of new promises can very quickly put us at odds with our primary duty. At the valuation date, the scheme’s funding position had deteriorated significantly – benefits were at risk of being under-funded.

Twelve months later, several funding metrics are still in the red, and members’ benefits remain at risk of being under-funded. As set out in questions 4 and 5, we would still (under a 2021 valuation) expect to have a multi-billion-pound deficit and the cost of funding new promises has continued to rise.

Continuing with the 2020 valuation is the required response under the Monitoring and Actions framework for the 2018 valuation. Abandoning it would also bring the Trustee into a breach of regulatory expectations.

We first made a commitment to carry out a 2020 valuation when we filed the 2018 valuation in the autumn of 2019. Among other things, it gave UCU and UUK the chance to consider the Joint Expert Panel’s (JEP) second report and potentially agree ways to mitigate or avoid members paying 11% of salary and employers paying 23.7% from October 2021 (per the 2018 valuation).

Continuing with the 2020 valuation was the only way to avoid October’s contribution increases (set as part of the 2018 valuation). There is still a chance these could be avoided – but this will only be possible if the Joint Negotiating Committee makes decisions relating to the 2020 valuation by the end of August. Even more potential or existing members may choose not to join or to opt out of the Scheme – out of having any workplace pension at all – the longer the 11% rate is in place.

TPR is also clear in its letter of 14 July 2021 to USS, shared with the Joint Negotiating Committee, that it expects the 2020 valuation to be completed “without delay, regardless of any decision in relation to a potential 2021 valuation…Any decision by the Trustee to conduct a 2021 valuation should not be seen as an opportunity by stakeholders to avoid or defer difficult decisions, making it less likely that an appropriate, sustainable outcome can be reached for the 2020 valuation in a reasonable timeframe…one of the options it may be appropriate for us to consider would be to set out a timetable for completion of the 2020 valuation in the form of an improvement notice.”

No. Our assets have increased in value since 31 March 2020 – but so too has the cost of funding the pensions already promised to members (our liabilities) and the cost of funding new pension promises (the ‘future service cost’).

That’s largely because:

• inflation is now expected to be higher (and the pensions promised to USS members are increased every year broadly in line with inflation); and
• expectations for future investment returns are now lower (meaning that more contributions have to go in to get the same amount out at the end).

So, as set out in question 5, we would expect the deficit to be lower than at 31 March 2020 but still materially higher than in 2018 – and the future service cost has continued to rise.

We have considered advice from the Scheme Actuary on how we would expect things to look as at 31 March 2021, based on the benefit package UUK has consulted employers on for the 2020 valuation and our proposed adjustments to its covenant support package.

As set out under question 1 and in a separate briefing note, we compensated for exceptional market conditions as at 31 March 2020 in ways that have been validated by ‘more normal’ conditions 12 months later.

For the reasons set out under question 4, our assets have increased in value since 31 March 2020, but so too has the cost of funding the pensions already promised to members (our liabilities) and the cost of funding new pension promises (the ‘future service cost’).

Our indicative analysis shows that the deficit as at 31 March 2021 would be £5.6bn – lower than in 2020, but still higher than in 2018. In line with the rates set under the last three valuations¹, we have assumed deficit recovery contributions (DRCs) would be set at around 6%. The annual future service cost is estimated to have increased (from 24.9% of payroll to around 25.6%) giving a total estimated contribution rate of around 31.6%.

The same figures for the 2020 valuation would be £14.1bn and 31.2% respectively.

This indicative outcome is based on the benefit and covenant arrangements UUK has consulted employers on for the 2020 valuation. A 2021 valuation would be much more challenging if those arrangements are not agreed and cannot be carried across.

The Pensions Regulator shared its position on these issues in its letter of 14 July 2021.

¹ 2017: £7.5bn deficit and 5% DRCs; 2018: £3.6bn deficit and 6% DRCs; 2020: £14.1bn deficit and 6.3% DRCs (based on the benefit package and enhanced covenant support UUK has consulted employers on for the 2020 valuation).

Our investment strategy has done its job in recent years in terms of generating higher percentage investment returns than an equivalent portfolio of liability-hedging assets involving index-linked gilts (see Question 8 for more on gilts).

But we have had a deficit ever since the global financial crisis in 2008/9 because the size of the scheme’s liabilities (the pensions already promised to members) at that point was much greater than the size of its assets. The liabilities have since grown at a faster rate, in monetary terms, than the assets.

This has been compounded in recent years as the cost of funding new pension promises has been greater than the contributions being paid towards them. That is the biggest challenge we face: the outlook for future investment returns is lower and the cost of funding new pensions has continued to increase.

- Our colleague Mirko Cardinale looks at these conditions in his analysis here and here.

That is as true for USS as it is for other DB schemes. SAUL (Superannuation Arrangements of the University of London) is a multi-employer DB scheme serving colleges and institutions that have links with Higher Education. It has reported its future service cost now stands at 35% of payroll (some 63% higher than in 2014). The ‘unfunded’ Teachers’ Pension Scheme has increased employer contributions to 23.68% – a 43% rise on the previous rate (16.5%).

Like all other private defined benefit (DB) pension schemes, USS has had to address a hard truth: the economic cost of funding ‘guaranteed’ pensions has increased over the past decade, due to high asset prices and lower expectations for future returns.

That is as true for USS as it is for other DB schemes. SAUL (Superannuation Arrangements of the University of London) is a multi-employer DB scheme serving colleges and institutions that have links with Higher Education. It has reported its future service cost now stands at 35% of payroll (some 63% higher than in 2014). The ‘unfunded’ Teachers’ Pension Scheme has increased employer contributions to 23.68% – a 43% rise on the previous rate (16.5%).

According to the Pensions Protection Fund, 89% of private DB schemes in the UK have closed to new members since 2006, while 48% have stopped offering DB pensions altogether.

USS members account for almost a fifth of the 1,089,000 people in the UK who are still actively paying into private DB schemes. We are in the 11% of schemes still open to new members.

Our primary legal duty as Trustee is to protect the benefits promised to, or accrued by, USS members to date. To do that, we have to identify the cost of securing those benefits – that is, the cost of paying a set income for life in retirement regardless of what happens to the economy in the future.

Of course, active members are accruing new benefits every day, so any underfunding of new promises can very quickly put us at odds with our primary duty, too. We have to consider that some members paying into the scheme today, or their beneficiaries, could still be alive and drawing their pension in 80 years’ time.

By law, the actuarial and economic assumptions used to calculate the amount needed to pay members’ benefits in future must be chosen prudently, taking into account an appropriate margin for possible adverse experience. The discount rate, yield on assets, anticipated future investment returns and mortality and other demographic assumptions must also be based on prudent principles.

We rely on economic growth and future investment returns to pay members’ benefits. Members’ benefits increase in value every year broadly in line with inflation. So, we need to have confidence in the returns we can achieve relative to inflation.

One way of looking at the economic cost of pension promises is to compare them to index-linked government bonds or ‘gilts’ (note, however, that we do not invest solely or even primarily in gilts).

Index-linked government bonds are the only investment which provide returns that are low risk and contractually linked to inflation. Every other type of investment comes with the risk of doing materially worse than inflation over time and hence worsening the scheme’s funding position.

Index-linked government bonds used to offer attractive yields relative to inflation (for example, in the 1990s the 20-year real yield in the UK was around +4%). However, since then real yields have fallen dramatically, and similar bonds today offer a negative real yield of -2.5%. That means, all else being equal, every year these bonds will actually lose 2.5% of their value (after inflation).

Say you want to ‘guarantee’ you will have £100,000 in real terms in 20 years’ time (the ‘guarantee’ being equivalent to a promise to pay from the UK government). If index-linked bond yields were like they were in the 1990s, you would only need to invest about £50,000. Today, you would need to invest about £170,000.

This is why delivering a strategy which beats inflation over time is harder (and much more expensive) than in the past. In fact, bond yields touched their lowest levels in history over the course of 2020.

We expect ‘riskier’ growth assets like equities to perform substantially better than low-risk, low-return assets like bonds over time. But unlike the pensions being promised to USS members, there are no guarantees (and so the returns we count on from these assets are effectively underwritten by the scheme’s sponsoring employers – and their resources are finite). Any estimate of how they will perform, relative to bonds or inflation, involves a substantial margin of error. The discount rate reflects the level of future expected investment returns we (prudently) plan to take credit for today in funding members’ pensions. Expected returns are highly uncertain, as is future inflation. In general, historical returns offer a poor forecast for the future.

Given the nature of the promises being made to members, we have to look at a sensibly diverse and appropriately secure range of assets. Here, the potential highs of equities and the fixed lows of bonds balance each other out.

We cover this in more detail here and here.

To the extent that contributions paid in the past were ultimately not enough to fund the promises being made, a defined benefit (DB) pension scheme will be in deficit. The total combined contribution rate paid by USS employers and members today does include payments dedicated to recovering the Scheme’s deficit.

At the same time, as set out in question 8, the economic cost of funding ‘guaranteed’ pensions has increased over the past decade. Pensions promised in the past – when conditions were more favourable – are no longer affordable at the same contribution rates. So, members today are having to pay more for the same promised outcome or even reduced terms.

In USS specifically, the default ‘cost-sharing’ rule brings another factor into play: any increase (or decrease) in the overall contribution rate is split 65/35 between employers and members unless the Joint Negotiating Committee (JNC) decides on a different split and/or changes the benefits to be offered in future.

The default ‘cost-sharing’ rule was introduced at the request of the JNC after the 2011 valuation in case it could not reach a decision at future valuations. It first came into effect under the 2017 valuation and has effectively seen members paying proportionately more towards new pension promises (the annual future service cost, or FSC) than in the past – as shown in the table below.

The JNC could decide, through the 2020 valuation, to take a different approach.

*Deficit Recovery Contributions paid by employers
** FSC was underfunded and no DRCs were paid

We can consider sustainability but must give due regard to our primary duty.

Our primary legal duty as trustee is to protect the benefits promised to, or accrued by, USS members to date.

Active members are accruing new benefits every day, so any underfunding of new promises can very quickly put us at odds with our primary duty. We have to consider that some members paying into the scheme today, or their beneficiaries, could still be alive and drawing their pension in 80 years’ time.

There needs to be a good degree of certainty that we will have enough money to pay the benefits that have been promised – and a very high degree of certainty that we will be able to rely on employers to fill the gap if we don’t.

In the 2020 valuation we have sought to find a reasonable balance. If we had only considered our primary legal duty, the contribution rates would be significantly higher. Because, through this lens alone, there would be no reason to follow anything other than a very low-risk funding strategy known as ‘self-sufficiency’².

Self-sufficiency is, at face value, riskier than insurance companies and banks would consider to be ‘low risk’, but we would be sufficiently confident that the pensions already promised to our members could be paid.

Taking such a low-risk approach would fulfil our primary legal duty. But it would cost around £30bn more than the value of our assets. It would mean raising contributions to a much higher rate and would make the cost of funding new pensions much less sustainable.

This shows the extent to which we have tried to balance our primary legal duty with the sustainability of the scheme: by relying on riskier, uncertain future investment returns to mitigate the rising ‘cost of certainty’ (see question 8) – but only to the extent employers can underwrite the risks.

A £30bn ‘self-sufficiency deficit’ is very large relative to the size of the HE sector (see Appendices A and B of our 3 March 2021 update). Its relative size is a key part of the long-term funding objective proposed by the Joint Expert Panel³. It is also one of key measures The Pensions Regulator considers when looking at the amount of risk being taken in our funding plan (reflected in its position on prudence).

² Under a ‘self-sufficiency’ strategy, the probability of requiring any additional contributions from employers if appropriately funded is around 5%.

³ “…The scheme will also ensure that, at all times, the proximity to full self-sufficiency assessed on a low-risk basis can be supported by employers over an appropriate time frame if the scheme were to be closed to future accruals.”