Much has been written about the death of defined-benefit pensions, and now former Bank of England governor Mervyn King and the distinguished economist John Kay have waded in, using the University Superannuation Scheme as their live example.
Writing in Times Higher Education last week, they claimed that defined-benefit pensions – inflation-linked pensions for life, based on final salary and the number of years worked – have been killed by “well-intentioned but inept” changes to accounting and regulation in the past 20 years. Moreover, the USS is in “rude health”, so the proposed closure to the 200,000 active members is unnecessary, they argued.
King and Kay are correct when they observe that defined-benefit pensions are all but dead in the private sector. Almost all of the UK’s 6,000 pension schemes have been closed to new employees for years, and most are now closed to current employees. They have been replaced by less generous defined-contribution pensions, leaving all the investment and longevity risk with employees.
Sadly, their attack on pension accounting and regulation is long on rhetoric and short on detail. Where are the nuts and bolts of the changes they want to see?
UK pension accounting was reformed almost 20 years ago, and all other countries have since followed. To give transparent information reflecting the underlying economics, companies must include the annual cost of new defined pension promises, and the market value of pension assets, liabilities and deficit, in their published accounts.
Annual pension costs and total liabilities are calculated by discounting future pension payment promises to a present value using the objective AA corporate bond rate.
Applying any “smoothing” or “judgement” to pension accounting would be a huge step backwards for company shareholders, lenders and regulators.
In describing the 1995 and 2004 Pensions Acts, King and Kay repeat the myth that companies are forced to fully fund pensions to remove all risk for members, as though “the fund could be closed down at any moment”.
Companies are, of course, required to back their pension promises with hard cash, but in truth, regulation is weak – pension deficits are not measured against an objective funding standard, and there is no set timetable to make deficit contributions.
Until 2003, companies could just walk away from their pension schemes, even if there was not enough money to pay all pensions. Should we scrap this and go back to the bad old days?
New “well-intentioned but inept” regulation also set up the Pension Protection Fund (PPF) lifeboat for scheme members when companies go bust. It is funded by levies on defined-benefit schemes, and it pays compensation, albeit less than the full pension promise.
The weaker pension regulation that King and Kay want – companies getting away with paying in less cash – would, inevitably, mean bigger PPF losses, lower compensation for members and higher levies.
They should explain how in practice would their proposals have hit the BHS and Carillion pension schemes, which both spectacularly imploded recently.
And is the USS is in “rude health”, as King and Kay claim, because “last year [it] received £2.2 billion [in contributions for employee members] and paid out £2 billion [in benefits to pensioners]”?
Measuring the health of a pension scheme using ”cash in for employees, cash out to pensioners” is the wrong measure – it is double-counting, verging on a Ponzi scheme. The £2.2 billion cash that the USS received is to pay for the pension promises being made this year to existing employees, not to pay current pensioners.
“Cash in, cash out” also leads to the absurd conclusion that before a new scheme starts any paying pensions, it is infinitely strong – “cash in for employees, no cash out for pensioners”, and that when a scheme closes to existing employees it is infinitely weak, “no cash in for employees, cash out for pensioners”.
A pension scheme’s financial health should be measured by comparing the value of its assets and the value of the pension promises it has made.
In 2007, the USS had a £2.5 billion surplus – £30.1 billion assets and £27.6 billion liabilities – on the market-based accounting measure required for all private-sector pensions. By 2018, assets were £63.3 billion but liabilities were £72 billion, giving a whopping £8.4 billion deficit.
Far from being in “rude health”, the USS has a huge deficit, which universities must plug by higher cash contributions over many years, squeezing teaching and research.
The root cause of the £11 billion deterioration over 11 years – a £2.5 billion surplus to a £8.4 billion deficit – is the USS’ long-term bet that equities would outperform boring bonds. In 2007, the USS’ strategic asset allocation was just 10 per cent in fixed and index-linked bonds, versus pensions in payment of about 40 per cent of liabilities.
Today, the USS wants to keep betting on equities, taking investment risks underwritten by universities that they would not dream of taking directly. To continue this bet – much larger than any bet taken by any UK hedge fund or investment bank – is reckless, threatening the long-term future of higher education.
Defined-benefit pensions were killed not by new accounting or regulations but rather by the doubling of the annual cost of new pension promises in the past 20 years. People are living longer and real interest rates have fallen, so the amount that must be put aside today is higher.
Universities are not immune – many have closed their individual pension schemes for non-teaching staff – and Universities UK is recommending the closure of the USS to control annual costs, and risk, just like other employers.
The USS Joint Expert Panel, which is to publish its report this month, cannot magically reduce the cost, and the risk, to universities of continuing to offer USS defined-benefit pensions.
Bernard Casey is a former research fellow at the Warwick Institute for Employment Research and a USS member. John Ralfe is an independent pensions consultant.