Thoughts on the next USS Valuation
Susan Cooper, 26 November 2015
The next valuation is only a year and a half away in March 2017. While the scheme changes
to be implemented in 2016 reduced the deficit in the March 2014 valuation to £5.3B, an
updatei to March 2015 increased this to £8.3B. This worsening in 1 year is despite the value
of assets having increased by £7.5B (18%), due to the £10.4B (22%) increase in the
discounted value of the liabilities. While not stated explicitly, it is likely that this update used
the same discount rate of gilts+1.7% as both the 2011 and 2014 valuations.
Questions were raised about the valuation method before the March 2014 valuation but
discussion was limited by time pressure. It would be wise to use the time now remaining
before the next valuation to study various valuation methods. Discussions between UUK,
USS and UCU and their respective actuaries should be encouraged.
Estimation of Investment Returns
Is it reasonable to use a fixed “equity risk premium” of above the current gilts rate to get the
best estimate of future investment returns? (This best estimate is then reduced by a fixed
margin of prudence, currently 1%, to give the discount rate used in the valuation.)
UCU has worked with First Actuarial to develop an alternative method to estimate an
independent internal rate of return for each category of investment, rather than relating all to
gilts. They have shown that this gives a less volatile estimate over the period March 2006
through March 2014 than referring all to gilts, as shown in the plot below.ii
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Reliance on the Employer Covenant (Test 1)
In July 2014, the USS Trustees published “An integrated approach to scheme funding”
(apparently no longer available on the web). It sets out a ‘Guiding Principle 1’ to avoid any
increased reliance on the employers’ covenant and to reduce that reliance if possible. This is
implemented as ‘Test 1’ which requires the difference between the discount rate used in the
valuation and gilts+0.5% to be bridgeable within a maximum employers’ contribution rate of
25%. Test 1 is thus a significant constraint on USS’s valuation method. It goes on to say that
this should inform the investment strategy required over the coming 20 years. Essentially the
possibility that USS might be wound-up at some time is used to push USS permanently
towards a lower-risk, lower-return investment strategy, reducing the level of benefits that can
be offered for a given contribution level.
This is particularly inappropriate for an on-going scheme in which income from contributions
is sufficient to cover payments of pensions. The last available cash-flow projection for USSii
showed it becoming slightly negative in about 20 years, but that was done before the benefit
changes, so an updated version may well stay positive throughout. This update should be
done.
An alternate approach would be to seek to accumulate a surplus as a source of extra funds to
be used in case of wind-up. Once such a surplus is achieved, it need merely be maintained,
and is thus a one-off cost rather than a continuous one. This would avoid an on-going
constraint on the investment strategy (assuming the surplus is allowed to be invested in the
same way as the rest of the funds). That is not a short-term prospect as we first need to get out
of deficit, but it could easily have been done in the 1990’s instead of reducing contributions.
It could become a realistic prospect once the current market situation normalises.
Prudence in Valuation Parameters
A degree of prudence is appropriate in the valuation, but it should be done with care. If
prudence is applied to multiple parameters, one easily ends up being more prudent than
intended.
A recent comparison of the valuation parameters of various pension funds by KPMGiii allows
a comparison of the USS assumptions to those of other DB pension schemes.
Discount Rate: Since most other DB pension funds are closed to new accruals and/or singleemployer schemes with much weaker convenant, it is to be expected that they use lower
discount rates. This illustrates the advantage to us (both employers and employees) of the
multi-employer status of USS which has allowed USS to have a more ambitious investment
strategy. It is not possible to derive from this report a comparison of the level of prudence
applied in terms of the difference between their best estimate of investment return and the
discount rate used.
Inflation: With the change to CRB, the rate of salary growth should become a less important
parameter for USS. This makes RPI inflation unimportant, whereas CPI inflation remains
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important because it is used in the revaluation of past accruals. The standard method of
estimating CPI starts from comparing the current rates for normal and inflation-linked gilts
and then applies two correction parameters: the assumed ‘inflation risk premium’ and the
assumed RPI-CPI difference. The KPMG report gives the most common assumptions as 0.2%
for the inflation risk premium and RPI-CPI=1.0%. The USS valuation used an inflation risk
premium starting at 0.2% and decreasing to 0.1% over 20 years, and RPI-CPI=0.8%. The
effect of these two parameters makes USS’s assumption for CPI start at 0.2% above the most
common assumption, rising to 0.3% above.
(The actual value of CPI at the time of the March 2014 valuation as calculated by the Office of
National Statisticsiv was 1.6%, compared to USS’s assumption of 2.6%. That looked
unusually low at the time, but so did the gilts rate. Both have decreased further since then,
with CPI around 0 since February 2015.)
Applying a prudence margin to both the discount rate and CPI is already double prudence.
This becomes even worse if, as seems likely, investment returns and CPI tend to rise and fall
together when viewed over the long term. Since they affect the liabilities in opposite ways,
the correlated part of their variation largely cancels out. It may be sensible to use the discount
rate minus CPI as the parameter to which prudence is applied, with that margin being
somewhat smaller than what is currently applied to the discount rate.
Life expectancy: While it may be true, as USS assumed, that USS members have a higher
average life expectancy due to higher average income, it seems unlikely that the rate of
improvement is also higher than average. However the USS valuation used 1.5% per annum
for the rate of improvementv, whereas the KPMG report gives 1.25% as the most common
value. Only 20% of schemes used 1.5%, 72% of schemes used 1.25% or below, and only 7%
used 1.75% or above.
i
p.81 of USS Report and Accounts for the year ended 31 March 2015 on
http://www.uss.co.uk/Annual%20Reports/reportaccounts2015.pdf (the 2014 value shown there is £5.4B, slightly
different from the final valuation number, but insignificant compared to the increase to March 2015).
ii
UCU circular UCUHE/257, Sept. 2015 on http://www.ucu.org.uk/circ/pdf/UCUHE257.pdf
iii
KPMG’s 2015 Pensions Accounting Survey on
http://www.kpmg.com/UK/en/IssuesAndInsights/ArticlesPublications/Pages/kpmg-2015-pensions-accountingsurvey.aspx
iv
Office of National Statistics data on CPI on
http://www.ons.gov.uk/ons/taxonomy/index.html?nscl=Consumer+Prices+Index
v
This rate of improvement seems to be the change of the Standard Mortality Ratio and I have no idea how to
translate it into the improvement in life expectancy. The KPMG report gives the additional information that
someone age 65 today will live an average 22.6 years more, whereas someone age 45 today will live an average
24.2 years past 65. That is an improvement of 1.8 years in 20 years, or about 1 month a year.
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