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22 November 2018

Perspectives on funding pensions

The issue of the ‘right way’ to fund USS pensions has generated much debate.

On the one hand, the trustee is accused of being recklessly prudent in its funding assumptions, and so requiring contributions that are unnecessarily high.

On the other, the trustee is alleged to be taking bets that the Higher Education sector might not reasonably be able to cash in, to keep pension promises unreasonably affordable.

These perspectives on pension scheme funding, and their associated arguments, are well-trodden ground.

One set of – strongly held – opinions holds that the past is a reliable guide to the future, and that returns on equities are likely to be enough to underpin the pension promises written by the scheme on behalf of employers.

This perspective works on the assumption that ‘return seeking’ investments will – over the long term – generate steady and robust income streams and, in this way, a pension scheme can be run most efficiently, and contributions kept appropriately low and stable.

Proponents of this view suggest that we should ignore whatever is the current ‘market price’ of the pension.

The alternative viewpoint suggests that the only number that matters is how much it costs today to buy the cash flows required to pay pensions in the future.

From this perspective, debt issued by governments and ‘investment grade’ corporates are the only way in which future pensions can reliably be secured, and so the price of buying cash flows that match promised pension payments in today’s market is the only sensible measure of the funding requirements of the scheme.

Currently, the gap between these two perspectives is very wide. This makes for difficult decisions in determining any funding deficit that exists in terms of past promises, and in setting the contribution rate required to buy the assets today that will fund pensions many years into the future.

The independent judgement of the trustee on these issues is a critical part of the checks and balances of running a mutual pension arrangement. All other things being equal, both employers and scheme members would like the trustee to keep contributions as low as possible. The trustee of the scheme, however, has no other agenda than to ensure that the pensions promised are secure, and the scheme is sustainable into the future.

The approach of the USS trustee does not fully satisfy either of the positions outlined above.

The scheme does depend on return-seeking assets to pay pension promises – as is entirely sensible for an open pension scheme with recourse to future payments from employers.

However, that dependency is limited in the longer term by the desire to manage the future calls that might ultimately be made on the sector if expectations of return-seeking investments turn out to be overly optimistic.

That is achieved by limiting the distance between the scheme’s funding target and a more market-based measure of solvency to an amount supportable by the scheme’s employers. This is a pragmatic way to budget risk-taking in the pension scheme over the long term within set parameters – parameters that are agreed by the scheme’s sponsors.

As at 31 March 2017, the cost of buying sufficient low risk investments to secure a greater than 95% chance of being able to pay pensions earned to date would have been circa £22bn more than our assets.

The trustee has no intention of funding pensions at that level of confidence while employers are willing and able to support the scheme – but neither the Trustee nor the scheme’s sponsors believe the current distance from being able to do so is comfortable, and would like to reduce it over time.

The plan is to do this in a pragmatic way, as the trustee’s views are that interest rates are more likely to increase rather than decrease in the medium term, which will help, and the intention is that the scheme’s reliance on riskier investments will also decrease, over a 20-year horizon.

However, the trustee must also manage potential scenarios that, over the short term, could make reaching that longer term destination more difficult. Significant falls in interest rates or in asset values from their current levels could mean that the distance from the market-consistent measure would increase in the short term, and be out of reach for the longer term.

The trustee’s plan must be as resilient as possible in these circumstances, too.

A critical feature of this pragmatic, middle-way approach to managing pension solvency is to have a clear view on the ability and willingness of the scheme’s sponsoring employers to find extra cash in future should it be needed.

That involves understanding the willingness to increase contributions in response to short-term market shocks, as well as long-term solvency challenges. The USS trustee received a very clear view on this from its sponsors in the course of the 2017 valuation – when it was asked to take less risk than was laid out in its original proposals.

Since then, however, the stakeholders’ joint panel has suggested that these views may have changed – and the UUK’s recent communications with the trustee has indicated qualified support for this view.

The trustee is prepared to reopen discussions on risk capacity and appetite with employers – but to do so in line with the laws governing pension schemes, it will need to complete the current 2017 valuation (with the increased ‘cost-sharing’ contributions that this entails) and hold an additional valuation as at 31 March 2018.

This is now in train.

Where there is a will on all sides, a 2018 valuation could be completed before the higher phases of cost-sharing come into effect from next October.

The trustee’s objective will remain the same throughout this process: to ensure that the defined pension benefits USS members earn can be paid as they fall due.