“It will be more expensive for members to manage the risk than it is for the employers”
The employers have committed to maintain their 18% contribution to the scheme but 18% into a defined contribution is worth substantially less to active members than 18% into a DB scheme. This difference explains why universities are determined to replace the DBs scheme.
The fundamental issues are relatively simple but tend to get missed or misunderstood in the technical detail. I first set out some background details on the scheme and the reasons why the employers want to withdraw from it. I then set out the costs to members which largely mirror the gains to the employers. In a defined benefit (DB) scheme the employer promises a specified pension payment (lump-sum and annual pension payment) on retirement. The amounts payable are fixed by a predetermined formula based on the employee’s earnings’ history and length of service. In a defined contribution (DC) scheme employee and employer contributions are invested with pension benefits determined by the proceeds of the fund on retirement and the market rate for the purchase of annuities. In April 2016 USS converted from a full DB scheme to a hybrid scheme with DB below the salary cap and DC above it.
1. It is very much in the short-term financial interest of universities to change the scheme from a defined benefit to a DC scheme
To understand why, one needs to understand how the financial risk associated with a defined benefit scheme currently lies with the universities. The universities are responsible for the liabilities of the pension scheme. Their responsibilities end only with the death of the last member of the scheme. However, universities have little control over how the scheme is managed and in particular how the risks attached to the scheme are managed and how the scheme is valued. The pension scheme fund itself is managed by independent trustees on behalf of the members and in the best interests of the scheme.
The management of the scheme is regulated by a non-departmental public body, The Pensions Regulator (TPR). A regulatory framework is needed to protect members from potential abuse of the fund by employers. Regulation has increased since the financial crisis in 2008 with wider powers and a more pro-active risk-based approach driven the Government’s wish to avoid expensive payments from the Pensions Protection Fund. In practice this means that TPR is more forceful in imposing on the trustees a tighter and more cautious regime in terms of its valuation of the scheme’s risk-bearing assets. This has a direct bearing on the valuation of the deficit.
As regulation has become increasingly onerous on all employers, they have sought to replace their DB schemes with DC schemes. Public sector schemes (for example the Teachers’ Pension Scheme) are backed by the tax payer and the security that this provides means that regulatory requirements are less demanding. USS is an independent scheme but while universities were funded by the state, it was the state that stood behind the scheme. Universities were officially classified as private sector from 2012 and private sector status leaves universities exposed to more cautious regulation.
Part of the regulation is a three yearly valuation of the scheme by TPR. The valuation of the fund is according to certain rules set by the regulator. These rules are subject to change. Where the fund is in deficit on the valuation according to these rules, the trustees approach the employer, the universities, to fund the deficit.
Remember the employers are solely responsible for the solvency of the fund and must make good any deficits. Remember also that the employers have very little control over the valuation of the fund – the investment strategy adopted by the trustees, the rules set for management and valuation by the TPR, the investment returns or the life expectancy of the scheme’s members. Since the financial crisis, deficits have increased. The USS deficit was £5.6b in 2014. I am aware of a range of estimates for 2017 with the FT reporting the highest at £17.5b. The valuation is arbitrary and depends on the assumptions made. Everyone will have a different view. It is the assumptions imposed by TPR which will determine the valuation which matters. (See data from Dr Woon Wong)
To anyone with any knowledge of the stock market, increasing deficits over this period may appear curious. The period from 2009 has seen one of the longest ‘bull runs’ in UK history. Stock market FTSE 100 valuation increased from 4,434 points year end 2008 to 7,604 points year end 2017, an increase of 3,170 points (71.5%). USS would have benefited from this to the extent that it was invested in equities. Unfortunately, its response to the financial crisis and stock market crash was to reduce its relative holdings in equities from roughly 70% to 30% of total funds. It moved into long-term low risk assets such as corporate and government bonds and probably also into Index-linked Government Stock (ILGS) (together 70%). As the Government’s financial crisis recovery policy of Quantitative Easing boosted equity prices, so it reduced returns on bonds and ILGS.
Even without the benefit of hindsight, an investment strategy which shifts from equities into bonds at the low point in the market looks ill-conceived. I do not know the extent to which the shift out of equities was led by the trustees or required by TPR or whether the need to match liabilities and assets exceeded the need to pursue investment returns. The point here is that the wholesale shift into bonds undermined the value of the fund. However, the valuation of the fund by the new rules of TPR undermined it a lot further. The consequence is that universities are faced with a very large deficit over which they have little influence but they are solely responsible for making good any deficit, whether real or artificial.
Faced with a deficit valuation, the trustees are required to produce a credible recovery plan. This comprises a request to the employers to pay the deficit through a lump sum transfer from the employer and/or increased contributions from the employer and/or the active members of the scheme. The scale of the deficit, over which employers have little control, explains why Universities UK is absolutely determined to get rid of the defined benefit scheme. It is absolutely in the short-term financial interest of its members to do so.
Of course there will be a long term cost of downgrading pension benefits, unless this is compensated through increased wages (this is unlikely). It is in the long term interests of universities to treat their employees fairly. An organisation that treats its employees badly for short-term gains acquires a bad reputation and in the long term will have difficulty attracting and motivating recruits. Universities need to recruit, retain and motivate pro-social, high-end knowledge workers. Academic staff rely upon long-term career structures and settled labour markets to undertake risky research over long time horizons.
A DB pension scheme can work for both sides – its role as a deferred payment acts to retain long-serving employees and its risk reduction in retirement allows staff to bear risk at work. Long-serving employees have skills specific to their employer and sector and they are therefore more productive in post than are external recruits. They are also uniquely qualified to train others in sector-specific behaviours and practices. The carrying of retirement risk has been one of the key features of the university as a good employer. At a time of increasing performance management, control and real wage cuts, the psychological contract for employees rests on these kind of continued employer commitments.
It has been my experience that the employer does not recognise the additional value of long-serving staff. Staff are seen as dispensable because there is a queue of replacements. It is my view that this queue is not what the employer believes it to be but belief in the queue remains strong. So, together with general temporal myopia (under-valuing the long term), the long term costs of ditching the DB scheme simply do not figure highly in universities’ decision making.
2. It is very much in the interest of current and future scheme members to retain the DB scheme.
This is more or less the reverse of 1. above. The challenges and costs facing the universities in managing the risks of the defined benefit scheme do not disappear when it is changed to a DC scheme. Rather these challenges and costs are transferred onto to individual scheme members.
The key message here is the strength of the employers’ determination to end the scheme should signal the value of what is being taken from employees. This value can be appreciated by describing what the DB scheme delivers to members. This is what will be lost if it is abolished. The DB part of the scheme comprises the lump sum and the annual pension payment. Under the defined part of the scheme, both are fixed according to salary and years of service.
To the member they are free of investment risk and free of life expectancy risk. Freedom from both risks has a value to a risk-averse individual. Most people are risk-averse most of the time. The value of risk is seen when risk-averse people require an additional return (a risk premium) to induce them take additional risk and conversely when they pay to avoid risk (for example in the form of a pension annuity).
Under the DB scheme the employers bear the costs of both risks. If the risk turns bad, the employer is responsible for the deficit payment. The bigger risk and the bigger driver of any potential deficit is the defined pension payments rather than the defined lump sum. The former includes both long term investment risks and life expectancy risks.
The removal of the defined pension is also the bigger loss to the member. The certainty of a guaranteed inflation-proofed annual payment for life is of great value in retirement. This value is reflected in the high cost of purchasing an annuity (the equivalent of the annual pension for life). When I consulted the market before Christmas, the cost of purchasing a pension annuity of £30,000 increasing at 3% pa at the age of 60 years was around £1 million. I expect that it is the high cost of purchasing an annuity that drives the estimated pension cuts in UCU’s First Actuarial Report: £6,000 less per year for a lecturer with 30 years membership, a starting salary of £40,000 and a finishing salary of £46,622; £7,300 less pa for a finishing salary of £58,655; and £9,600 less for a finishing salary of £110,217.
Of course there is no obligation to purchase an annuity, and this is why Universities UK state that they don’t recognise the figures. They are looking at the £1million instead. If members don’t buy an annuity, they live with investment and longevity risk. The lump sum will almost certainly not be exhausted at the exact moment of death. It might have run out sooner leaving the member in financial difficulties.
Alternatively, it can be difficult to spend the lump sum when the retired individual doesn’t know how long they will need it for (because they don’t know when they will die). For this reason, cautious retirees tend to save more than they would otherwise prefer to do. Both investment risks and longevity risks currently lie with the employer. They will be transferred to the members under this proposal.
“The transfer of risk (investment and life expectancy) borne by a large multi-employer collective under the DB scheme to individual members in the DC scheme is inefficient because it shifts risk from the employers who are better able to bear and manage risk (and at a lower cost) to individuals who are less able to bear and manage risk and who pay a higher cost to do so.”
The price of purchasing a pension annuity has increased over time as annuity rates have fallen. Annuity rates have fallen for the same reasons as liabilities under the defined benefits scheme have increased – increased life expectancy, very low interest rates and tighter more risk-focused regulation.
Under the DC scheme, it is the member rather than the employer who bears the increased cost of these risks. Under the defined benefit scheme it is the employer. The risk and the cost of the risk are present under both schemes. It is the party who bears responsibility for meeting them that changes. The proposal seeks to shift it from the employer to the member. This cost is reflected in the estimated pension reductions reported by First Actuarial.
There is a further public interest argument in favour of the DB scheme. This is relevant because universities have a public value motivation. The transfer of risk (investment and life expectancy) borne by a large multi-employer collective under the DB scheme to individual members in the DC scheme is inefficient because it shifts risk from the employers who are better able to bear and manage risk (and at a lower cost) to individuals who are less able to bear and manage risk and who pay a higher cost to do so. In short, it will be more expensive for members to manage the risk than it is for the employers.
Ultimately though it is the transfer of cost of investment risk and life expectancy risk from the employers to the employee that it is dominant. It is a cut in the reward package and, for many people, it will be a very big cut.
V J Wass January 2018
Additional presentations prepared:
- Dr Woon Wong in association with Professor VJ Wass shows that the impetus to close the USS Define Benefits Pension is additionally based on an unnecessarily cautious extrapolation from an artificially low gilts yield in Aug 2016: The Phantom Deficit of Our USS Pension – 20180220
- The UCU Branch at University College London prepared the following summary of what is wrong with USS: UCL UCU Pension Factsheet