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4 September 2019

Hindsight 20/20

As the saying goes, hindsight is 20/20 – and this is particularly salient when reviewing investment performance.

The “right” investment decisions are revealed and obvious in retrospect, judged over chosen time intervals. But decisions must be made in prospect, based on expectations, probabilities and risk tolerances.

Clairvoyance would have been extraordinarily rewarded over recent years by owning more index-linked gilts (UK government bonds) on a leveraged basis within a liability-driven investment (LDI) strategy.

The future income streams provided by buying index-linked gilts match the profile of the promised inflation-protected pension payments we will need to make to members in future, and so provide one objective measure of the cost of funding benefits with a high degree of certainty.

Gilt prices rise inversely to their yields, and index-linked gilt yields (along with others including German and Japanese government bonds) have fallen to the lowest levels in history. Ten and 30-year index-linked gilt yields at the end of August were at minus 3% and minus 2.25% respectively.

These lower “risk-free” yields imply that promised, inflation-protected benefits have become more expensive than ever.

Some commentators have recently suggested that USS could and should change its approach to asset allocation – the types and balance of assets it invests in – to one that has been better rewarded by market conditions over the past few years.

But an allocation that happens to have performed best over recent years could be a poor prescription for the future.

Yes: owning a lot more index-linked gilts, either by replacing “riskier” return-seeking assets or on a leveraged basis, would reduce the day-to-day volatility of the scheme’s funding position.

But doing so at today’s yield levels would, on our expectations, suppress the future returns of the scheme which would further increase the required contributions to fund the benefits that our members are accruing in our DB fund.

Furthermore, given the scale of the USS DB fund (over £72bn at the end of August 2019), changes to our asset allocation need to be implemented gradually to reduce adverse market impact: the total market value of over 15-year index-linked gilts is £550bn. Most of these bonds are owned by other DB pension funds – the vast majority of which are now closed to further benefit accrual. Annual issuance is £15-20bn.

USS is pursuing a strategy for the long-term, and necessarily played out over many years.

Over the past 10 years, the fund has substantially diversified its asset allocation, though remaining substantially return-seeking. In our Reference Portfolio (or broad strategic asset allocation), Equities and Property have been reduced from 90% to 65.5%. Fixed income has increased from 10% to 46%, including 11.5% of leveraged LDI.

In our implemented portfolio, we are using our scale and capabilities to build up a more widely diversified portfolio, including over 25% in Private Market Assets (see: An alternative approach to funding pensions?), such as infrastructure (renewable energy, transport, gas distribution etc), private credit and property.

We explain the differences between and purposes of the reference and implemented portfolios on Page 20 of this year’s Report and Accounts.

Comparing investment returns across funds requires some care: different circumstances (maturity of scheme or time horizon, expectations and risk tolerances) will inevitably lead to differences in investment strategies.

Our DB fund assets have grown from £26bn to £72bn over the past 10 years and, within Mercer’s universe of large UK pension funds, USS was placed in the top quartile over the five years to end 2018 (the latest comparative data available). As illustrated in our annual report, over medium-term time intervals, investment returns for our DB fund have exceeded the Reference Portfolio benchmark and the gilts proxy for the scheme’s liabilities – and our latest estimates show this remains the case over 3, 5, 7 and 10 years to the end of August.

Past performance is not the problem – although, naturally, it could have been even better with the benefit of hindsight.

The problem is a forward-looking one: extraordinarily low “risk free” gilt yields and lower long-term return expectations across asset markets have sharply raised the contributions required today to support accrual of promised inflation-protected pension benefits.

These challenges are already manifest in the rarity of open, funded defined benefit pension schemes: the vast majority of the UK’s schemes are now closed, to new members or in full. In fact, USS accounts for nearly a sixth of the people still actively paying into the schemes that remain open.

Even the Teachers’ Pension Scheme, whose pensions are “unfunded” and, in that sense, a direct call on the taxpayer, is significantly increasing the contributions required in return for defined benefit pensions.

In the face of these challenges, USS’s investment governance has focused on careful assessment of future return prospects and probabilities, risk tolerance, and the best, sustainable long-term strategy to support our members’ current and future pensions.