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22 July 2021

Investment strategy effectiveness and the 2020 valuation

Has our investment strategy been effective?

Reflecting the long-term nature of the pension arrangements of our members, we take a long-term approach to investment strategy. The overall balance of our investments in the defined benefit (DB) section reflects the primary objective of any DB pension: to provide members with a set inflation-linked income for life in retirement, regardless of what happens to the economy in the future.

The investment strategy we (and any other DB pension scheme) follows involves an approach that balances two goals:

  • Goal 1: Generate returns
  • Goal 2: Manage the risks between assets and liabilities

The first of these goals – generating returns – aims to reduce the contributions that are needed to fund future pension benefits. This involves investments in return-seeking growth assets, such as equities or property.

The second of these goals, managing investment risks, aims to reduce the chance of extremely bad outcomes, keeping the scheme within our risk appetite and within the risk capacity of its sponsoring employers.

This typically involves two risk-mitigating activities: (i) diversification and (ii) hedging.

Diversification involves spreading the allocation to higher-risk growth assets across different types of these assets and ensuring that the aggregate risk profile of assets and liabilities is appropriately balanced. The size and scale of USS demands diversification in the way we invest.

Hedging, the other risk-mitigating activity, involves offsetting the risks associated with the pension liabilities (specifically inflation and interest rate risks) with similar – but opposing – risks associated with assets.

Hedging helps to deliver proportionately greater certainty in the scheme’s funding plan and reduces the risk that we are unable to generate the cash flows that will be required in the future to pay pension benefits. It also ensures that the amount employers might need to pay in the future to secure members’ benefits is within their means to fund.

However, since hedging assets typically have lower expected investment returns than growth assets, there is generally an opportunity cost to hedging, which corresponds to the difference in expected returns between these two types of assets.

In summary, the investment strategy of any DB pension scheme comprises, broadly speaking, growth assets to generate investment returns and lower the contribution cost of pensions, and liability-hedging assets to limit risk.

A key element of setting investment strategy is determining the appropriate balance between risk and cost of contributions. This balance is informed by consultations at each full valuation.

Has our hedging strategy been effective?

We have recently completed an analysis of how effective we have been in balancing these investment objectives since the 2014 valuation. It was in the 2014 valuation that progressive de-risking of the scheme over time was established as part of the investment strategy and this has remained so ever since.

We have done this analysis by comparing actual investment performance with two counterfactual scenarios – one with more hedging and one with less hedging.

The current approach to investment strategy was implemented on 1 January 2015, when the Technical Provisions (TP) deficit was £9.1bn. At that time 21.6% of assets were allocated to hedging assets (specifically so-called LDI, or liability driven investment, assets).

On the date of the 2020 valuation, 31 March 2020, this allocation had grown to 33.3% and a year later by 31 March 2021, it had reached 36.5% of (a larger) asset value. By the 2020 valuation date, the TP deficit had grown to £14.9bn (based on ‘Scenario 3’ for additional covenant support, per our update of 3 March 2021).

- Note that counterfactual analyses such as these depend on assumptions about hypothetical decisions and holding everything else constant. In particular, this second counterfactual is based on some broad assumptions about the cost of leverage and that hedges could indeed be acquired at the assumed maximum rate without reducing the allocation to growth assets. In comparison, the first counterfactual is slightly more robust.

This analysis shows that the decision to increase the level of hedging since 2015 has been beneficial. We could have hedged more and been better off. We could have hedged less and been worse off.

How effective has our investment strategy been at generating high returns?

Over the medium-term and the long-term, our investment strategy has done its job: it has generated higher investment returns than an equivalent portfolio of liability hedging assets involving index-linked gilts. This is despite falling real yields generating significant returns for the latter over this period.

Figures (unaudited) to 31 December 2020 show a realised investment return of 10.9% p.a. over five years, which is 1.7 percentage points higher than an equivalent portfolio of index-linked gilts.

Given this high level of outperformance, why has the self-sufficiency deficit increased? The key drivers include three effects unrelated to investment performance:

  • The reform of RPI inflation is an extraneous factor that has increased the cost of funding our DB pension liabilities, which are linked to CPI.
  • The cost of new liabilities that have accrued over the period has been greater than the future service contributions that have been received, widening the gap between assets and liabilities.
  • The initial size of liabilities was much greater than the initial size of assets. Our investment strategy has generated a higher percentage return from the assets than the percentage financial return on the liabilities – but the liabilities have grown more in monetary terms than assets. As a result, the deficit has increased.

So, the increase in the deficit is not because of poor investment returns on growth assets: on the contrary, they have delivered the high returns they were expected to generate.

This article is issued by Universities Superannuation Scheme Limited (the “Trustee”) in its capacity as the sole corporate trustee of the Universities Superannuation Scheme. The Trustee is not an actuary and cannot provide actuarial advice.

Therefore, Technical Actuarial Standards do not apply to the Trustee or to the provision by the Trustee of this article. Where actuarial information produced for the Trustee has been incorporated as part of, or summarised in, this article, the relevant actuary has confirmed to the Trustee that the actuarial information complied with applicable Technical Actuarial Standards. The Trustee is sharing this article for information purposes only and on a non-reliance basis. Nothing in this article constitutes advice. Accordingly, it is important that you take any necessary professional advice, including actuarial advice, that you feel you need on the contents of this article. Neither the Trustee nor its third-party advisors accept any liability to third parties in relation to the information in this article.