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.