USS is the biggest pension scheme in the UK by assets (£60bn at 31 March 2017) and backed by over 350 employers, including all the oldest and most prestigious universities in the Higher Education sector. We are not immune to the substantial challenges of providing a retirement income in a world where the future looks more uncertain.
Our relationship with the Higher Education sector, with the ability to call on future contributions with some certainty to ensure pensions earned to date are secure, means that this approach to managing the risks is at its heart a contract between generations of contributors to the scheme.
USS decision making
USS, as the trustee, runs the scheme solely for the benefit of our members on behalf of our sponsoring employers. Key decisions on future benefits and how the corresponding contribution requirements are split, are negotiated directly between employer and member representatives.
The trustee’s role is to set a contribution level that will cover the costs of providing future pensions to current employees, as well as repairing any deficit in respect of pensions already earned to date. The trustee determines the cost of providing a promised £1 of pension impartially, based on detailed expert forecasts and analysis. The pricing is reviewed at least every three years at a valuation.
Taking independent advice, we identify the maximum investment risk we assess employers can reasonably take in supporting the scheme, given their collective financial strength. We consult on this view so that employers (through UUK) can say whether they wish to take a lower level of risk into the funding approach. The appropriate level of pension risk to take is a judgement scheme's employers must make given their broader commercial and strategic priorities and the risks attaching to these. Opting for lower pension risk increases the current cost for pensions but reduces the likelihood that further changes may be needed in future.
USS has always looked to work within this framework to provide high quality pensions at reasonable cost with the security of the pension once offered and accrued foremost in our minds. The funding charge for current pensions is driven by trustee’s views of the future. Our board of non-executives, with strong independent representation along with UUK and UCU appointees, makes the decisions based on extensive analysis from the executive and external independent advice.
Employer and member representatives, through the Joint Negotiating Committee, then decide how to shape the scheme – in terms of the benefits provided and cost-sharing arrangements – based on the trustee’s views on costs. The trustee can help support stakeholders in making their decisions through impartial, expert analysis of potential options, but does not make these decisions.
When the future looks very different from the past, as it does now, these can be challenging processes, requiring difficult decisions.
Pricing our pensions
The cost of a given level of pension can only be ‘guaranteed’ by buying that pension at market prices through an insurer. Such arrangements are expensive, reflecting the fact that - unlike an employer's pension promise - they are an arm’s length transaction, with no recourse by the insurer for more money should they subsequently find out they have undercharged. A quick look at annuity rates shows that the price of a benchmark annuity has risen by about a quarter for those at retirement age since between March 2014 and March 2017.
You can’t actually buy the pension USS provides on the open market but the closest match suggests one year’s accrual of defined benefit pension would cost around 50% of pay for a 65-year-old. USS currently prices this pension for a joint contribution from employers and members of 26% of pay.
Setting a contribution rate requires a judgement on the returns that can be earned by that money when invested by the scheme. In agreement with our sponsors, USS backs pension promises with a diversified portfolio of assets, seeking to deliver superior performance over the long term. We have about a half in equity-like investments, one-third in fixed income and the balance in infrastructure, property, private debt, commodities and absolute return. We have to make prudent judgements on the return expectations for those assets when placing a value on the pensions promised to date and those to be offered in future. We consult on these arrangements with sponsoring employers every three years.
If it proves in future that the returns assumed in making previous promises are now less likely to be achieved in practice, then future contributions have to rise to account for that. Paying more to provide for past promises - assuming there is no recourse to extra funds - reduces the amounts available to provide for future pensions. The same circumstances could also increase the predicted cost of pensions for future service. The judgement on how much risk to expose future generations of employers and members to in order to offer a defined level of pension today is a difficult one, as it involves taking a view on the future, a view which may be informed by the past but is inherently uncertain.
Nevertheless, the trustee must look to set a rate that minimises the likelihood of unmanageable deficit recovery payments arising in the future. This is a key task in seeking to manage intergenerational fairness. There is no single “right answer” to this process, and is constrained mostly by the need to ensure that if the assumptions are wrong, they are not so far wrong that it creates real problems for future contributors.
At the moment, on our best estimate for future returns, we actually have a substantial surplus but depending on the level of prudence applied to these judgements then there is a deficit to continue to manage over the long term.
Of course, the first job of the trustee is to ensure that pensions already promised are very secure. USS pensions are backed by a diverse portfolio of assets and a strong university sector. The organisations that contribute to USS have a payroll of £8bn, we collect £2bn of contributions in respect of 190,000 contributing members, and the many strongest employers can be expected to remain so for a long time to come.
Steering this scheme requires taking measured, balanced, collegiate decisions with a horizon of the next 20 years and beyond. While we cannot over-react to short term volatility, neither can we miss any signals about structural changes to the prospects for growth and returns.
Our current challenge in the 2017 valuation
The solvency position of the fund in respect of past service is subject to a valuation every three years, and monitored between these triennial valuations by keeping the same fixed margin over gilts, to discount future pension cash-flows to present day values. This provides an estimate of the funding position and triggers for when a response might be required to keep the scheme in balance. Since the last valuation in 2014, the price of government debt has increased. As a result, the expected future returns have declined significantly. This increases the value placed on the liabilities under this measure, as it is seen as a harbinger of future lower returns across all asset classes.
For USS, the same factors that have driven the rise in gilt prices have seen all our assets rise substantially in value since 2014. Our active managers have also outperformed: over the five years to 31 March 2017, they have generated an average return of over 12% p.a., substantially outperforming gilts and adding £1.1bn of extra value against their benchmark after all costs – costs that are about £34m lower p.a. than large global pension fund peers.
However, using the 2014 valuation approach, we estimated in our Report & Accounts, the deficit to be £12.6bn at 31 March 2017 – larger than 2016’s estimate. This is because the scheme itself is larger, as assets and liabilities both grew. The scheme’s funding ratio remained at 83% at the end of March 2017 using the 2014 valuation approach.
We will be reviewing the funding plan through the 2017 valuation. We believe that the scale of the deficit will be less than these monitoring numbers suggest (we believe interest rates will rise moderately more than the spot market price suggests) – and that the deficit ought to remain within the long-term affordable means of employers.
The bigger problem is the reduced expectations for returns on any money we can invest today. This drives up the cost of providing a promised £1 of pension for future service, and this will bring challenges for the funding framework outlined earlier.
This means there must be flexibility in approach, and an open and transparent review of the options. This process is underway with UUK and UCU exploring options for future pensions and cost sharing.
The closing view
For a pension scheme to work, contributions, investments and benefits have to be in balance. Judgements must be made about the future. Where judgments are required, risk is taken, and the trustee role is to ensure that the risk is proportionate to the willingness and ability of those underwriting the risk to respond.
There is no simple solution to providing a good level of pension, for an acceptable cost and within defined investment-risk parameters. Pensions promised now depend on the next generation being willing to pay more in future if necessary to make good on past promises. For the intergenerational contract to work, the current generation must do its best to ensure that the risk of placing too high a burden on future generations is not too big. That limits the amount of guarantee that can be built into the pension promise, and explains the transition of USS away from a fully defined benefit scheme towards a hybrid arrangement
The sector has taken decisive action in recent years to seek to ensure the intergenerational contract is managed within reasonable boundaries. These are considerable challenges – but USS’s structure means the sector itself, acting through its employer and member representatives UUK and UCU, can shape the scheme to address these factors. The sector has, in the recent past made difficult decisions to raise contributions and reduce promised benefits. Some will say the changes went too far, some say they did not go far enough.
Whatever course is set for the future by stakeholders, USS will continue to provide high quality pensions tailored to meet the needs of the Higher Education sector, and will look to work with employers and individuals to balance the complex and unpredictable factors that affect everyone saving for their retirement.