Discussing deficits

21 February 2018*

Last summer we published our Annual Report & Accounts and announced that, as at 31 March 2017, our assets had grown in value by more than £10bn in just 12 months, to £60bn.

But it was our funding deficit that made headlines and, since then, USS’s funding position has been the subject of some debate as we’ve carried out our latest triennial valuation.

So what exactly is a deficit and what figure should members focus on?

In simple terms, a deficit is the difference between the amount of assets held and the amount of money estimated to be needed to pay the pensions built up.

There are different ways of estimating the money needed to pay pensions built up and different ways of measuring a deficit, so let’s start with what we reported in our 2017 Report & Accounts.

The figures given in our Reports and Accounts were on our monitoring basis and reported liabilities of £72.6bn – a funding deficit of £12.6bn and a funding ratio of 83%.

As the name suggests, the monitoring basis is an indicator. It uses all the funding assumptions we made in the 2014 valuation – when we last formally reviewed them – except for the yield on government bonds (known as gilts). This is the only measure we continually update between valuations as it provides a rough estimate of any changes in expected investment returns over time, which is a key factor influencing the scheme’s underlying funding position. The monitoring framework assumes that the other assets in which we invest continue to provide the same level of out-performance above gilts as we assumed at the valuation date, 31 March 2014. There is a reasonable empirical and theoretical basis for using this metric to monitor our funding position, and we look at all aspects of funding from first principles at each triennial valuation.

We can see from our Chief Investment Officer Roger Gray’s analysis how gilt yields have moved since 2014: Investment challenges: the facts

The indication we took from the monitoring position was that while the value of our assets had grown considerably in a relatively short space of time, the outlook for future returns had also changed. This is intuitively credible, as the price rise indicates that in a world of lower future returns, investors are prepared to pay significantly more to secure future cashflows. We’ve since looked at this in great detail for the 2017 valuation and, while there has been significant focus on the existence of a deficit, it is actually the outlook for future returns that has had the most material influence on the outcome.

While there has been significant focus on the existence of a deficit, it is actually the outlook for future returns that has had the most material influence on the outcome.

Another measure given in our Report & Accounts was the formal accounting measure – the ‘FRS102’ basis. This costs all of our liabilities solely based on the market prices of long dated AA corporate bonds. This is intended to provide a consistent and objective basis by which all such pension obligations are measured for reporting in company accounts.

On this measure, we reported a deficit of £17.5bn. Crucially, this is not the measure on which the trustee and its stakeholders base decisions on the level of contribution required to fund benefits provided by the scheme or on the scheme’s benefit structure. Nor could it be, as there aren’t currently sufficient long-dated AA corporate bonds available in the market for this measure to become reality. This is an accounting measurement that is intended to require a single, consistent economic basis for all corporate reporting related to pension scheme funding.

Instead, the scheme’s funding plan uses a prudent expected rate of return for the scheme’s actual assets to place a present value on the liabilities to determine the future contribution requirements.

The scheme’s actual assets are invested in a diversified portfolio – broadly 60% equity-like, 40% bond-like – that is consistent with the scheme’s risk budget agreed in consultation with employers.

The scheme’s actual assets are invested in a diversified portfolio – broadly 60% equity-like, 40% bond-like – that is consistent with the scheme’s risk budget agreed in consultation with employers.

Finally, on a ‘self-sufficiency’ basis, we reported a £27.4bn deficit. This is the trustee’s measure of the amount of reliance being placed on the employers to support the scheme now and in the future. Self-sufficiency represents how much we would need to invest in a low risk portfolio that gives at least a 95% confidence of having sufficient monies to pay all pensions earned to date with no further contributions from employers or members for those benefits.

You can see how this measure influences our approach here.

All of these measures serve distinct purposes.

They are not based on the trustee’s ‘best estimate’ view which would, in fact, see us reporting a funding surplus. That’s because our ‘best estimate’ by definition only has a 50/50 chance of success and in order to ensure USS pensions promises are properly secure, and to be compliant with legislation, we have to apply a degree of prudence to our calculation of funding requirements.

Our ‘best estimate’ by definition only has a 50/50 chance of success and in order to ensure USS pensions promises are properly secure, and to be compliant with legislation, we have to apply a degree of prudence.

Since the Report & Accounts was published, three further deficit figures have been reported as we’ve carried out the latest valuation:

The fact these deficit figures are a matter of public record reflects how we have conducted one of the most open valuations of any pension scheme in the country; we have updated members and stakeholders at key milestones of the process; we have published summaries of our investment strategy and performance, our valuation approach, and the key factors influencing the scheme’s funding position as we stepped through a very robust and rigorous process to address the 2017 valuation.

So, the most up to date position (as of May) is a funding deficit of £7.5bn – a prudent estimate backed by more than £60 billion in assets, which means the scheme is 89% funded.

It would require all of 350-plus sponsoring employers to, effectively, become 'insolvent' before there was any prospect of the benefits members have already built up in the scheme being affected by a deficit – but it needs to be addressed, and it will be addressed through the valuation. We will establish a recovery plan that will require additional contributions from employers over a number of years that will be specifically dedicated to closing the funding gap.

And while our funding position may fluctuate, our position as a significant, long-term, responsible investor will remain a constant.

That is the assurance all members can take from this process.

The existence of a deficit – faced by two-thirds of UK defined benefit pension schemes in January 2018 – does not affect our ability to make sustained investments over several years, aligned to our rolling five-year investment targets. Again, we can see from Roger’s analysis how successful our long-term approach has been: Investment challenges: the facts.

But it is clear that the outlook for future investment returns has changed since the last valuation: much lower prospective investment returns across the majority of asset classes have seen the estimated cost of accruing future defined benefits – in their current form – increase by a third.

Lower future expected returns have to be offset by higher future contributions, reduced future benefit promises - or a balance of the two. This is the factor that has been the most influential driver of the benefit reforms recommended by the Joint Negotiating Committee.

*This article was first published on 21 February 2018, and was subsequently updated in May 2018.

Last updated: about 6 months ago

Guy Coughlan Guy Coughlan

Chief Risk Officer