Imagine you had a Pounds 1.4bn windfall

June 9, 2000

Actuary Zaki Khorasanee sets out why academics should demand that their pension fund's surplus be used to improve their 'mediocre' rights.

I joined the Universities Superannuation Scheme in September 1998, more than six years after starting my university career. As a pensions actuary turned lecturer in actuarial science, I was in a good position to evaluate the scheme before joining.

The USS has a typical benefit structure for a public-sector scheme, in that a pension of an 80th of an academic's final salary (multiplied by the number of years of service) is supplemented by a lump sum of three times the pension. This is worth slightly less than the 60th of a worker's final salary (multiplied by the number of years service) typically provided by private-sector schemes. So far, private pension schemes come out on top.

But we should not overlook the USS's compensating factors:

* Inflation-proofing of all pensions (most private-sector schemes apply a limit of 5 per cent a year)

* Liberal early-retirement terms that appear to allow an employee to retire from age 60

* A reasonably good ill-health retirement pension, although the value of this benefit depends on how generous the trustees are in interpreting "ill-health".

I did not join the scheme when I first became a lecturer because of the relatively high employee contribution rate - more than 6 per cent of salary. This made the scheme poor value for young employees who could otherwise take out personal pensions that were effectively subsidised by the government during the late 1980s and early 1990s.

According to the latest actuarial valuation in March 1999, the USS enjoys a healthy surplus of Pounds 1.4 billion. In these pages, Andrew Oswald, professor of economics at Warwick University, suggested that this could be used to increase pension payments to two-thirds final salary.

This is clearly fantasy: Pounds 1.4 billion may sound a lot, but using the whole of this surplus would result in only an 8 per cent increase in the pension earned from past service - a lot if you have 40 years' service, but not much if you have just started in academe and certainly not enough to take you anywhere near a pension worth two-thirds of your final salary.

Furthermore, the actuarial valuation report tells us that 53 per cent of this surplus has already been spent - Pounds 561.3 million is being used to reduce the contributions employers (universities) make to the scheme, while Pounds 201 million is being used to make minor benefit improvements. This leaves an unused surplus of only Pounds 680 million. This could fund only a modest improvement in benefits, such as increasing the pension earned from past service by 4 per cent or reducing employee contributions by 0.5 per cent of salary.

Who owns the surplus?

Oswald raised the question of whether the USS was right to use the surplus to reduce employers' contributions rather than further increase employees' benefits.

The USS is a "defined-benefit" scheme, which means the employer promises to pay the benefits set out in the rules, irrespective of the investment performance of the fund. Employers would be entitled, under these rules, to take a "hardline" view on the question of how to spend the surplus. This would argue that the assets of the fund are there to provide security for the benefits promised to employees, who would have no right to any of the assets unless employers reneged on their promises. Yes, employers pay lower contributions if a surplus arises, but they also take the risk of paying higher contributions if a deficit arises. Employee contributions, on the other hand, are always fixed.

In practice, the situation is not so clear-cut. First, the pension scheme is part of an employee's remuneration package and improvements in pension are a legitimate means of increasing that overall package. Given the long-term decline in academic salaries, there must be a moral case for the prudent use of the pension surplus to improve our rather mediocre pension rights.

Second, a pension fund does not belong to the employer, but is a trust fund managed by trustees who are legally obliged to act in the members' best interests. The powers and duties of the trustees vary from scheme to scheme. They are set out in the scheme's legal documentation. Suffice it to say that the use (or misuse) of surplus assets in private-sector schemes has been the subject of litigation, and the avoidance of such litigation depends on the employer and the scheme members arriving at a reasonable compromise.

Could the USS pay a pension of two-thirds final salary?

Let us assume that common sense prevails and the USS trustees allocate a share of the surplus to improve the benefits. Which benefits should be improved and by how much? There are major financial and ethical problems with using the surplus to provide a pension of two-thirds final salary, as Oswald suggests. First of all, would the change apply to all current and future USS members? If so, we would be using a finite amount of money to pay for unlimited extra pensions.

Amazingly, this is theoretically possible, but it would require the USS to maintain the Pounds 1.4 billion surplus indefinitely and use just part of the interest earned on it to fund the improvement in benefits. The interest earned on the surplus would need to exceed the growth in employees' salaries, and only this excess would be available to pay for the extra benefits. I do not believe the USS surplus is nearly big enough for this strategy to work.

So suppose we restrict the improvement to current employees. This would be more affordable, but would it be fair? Pensioners and deferred pensioners would get nothing, while employees with 40 years' service at retirement would get little extra. Those who would gain most would be employees with about 20 years' service at retirement.

The most sensible way of using a surplus to improve benefits is to apply a fixed percentage increase to the accrued pension rights of all members - pensioners, deferred pensioners and active members. By "accrued pension rights" I mean pension rights earned from past service. Pensioners and deferred pensioners would then get a fixed percentage increase in their pension, whereas active members would effectively have their past service in the scheme increased by some fixed proportion.

Another option would be a modest reduction in the amount of money academics pay monthly. Although this would be an unlimited improvement (affecting current and future generations of employees), it might be affordable. This would give employees who have recently joined the USS (such as myself) a noticeable reward.

Why has the USS changed its approach to valuation?

Is the scheme's actuary hiding the "true" surplus by making assumptions that are too conservative? The method and assumptions underlying the latest actuarial valuation certainly represent a departure from the approach taken in the valuation in 1996. This change initially aroused my suspicions. But, for the puposes of comparison, the actuary also did the 1999 calculations on the basis he used in 1996. On this basis, the Pounds 1,442.8 million surplus in March 1999 would have been - wait for it - a deficit of Pounds 1,103 million. So one could argue that the surplus in March 1999 was entirely down to revised methodology.

But having studied the figures, I believe that the change in methodology was entirely justifiable and the surplus disclosed in March 1999 a real one.

In conclusion, the surplus in a defined-benefit scheme does not belong to the members of the scheme, but must normally be shared in some agreed manner between the members and the employer. The most productive strategy for academics would be to press for incremental improvements in pension rights linked to past service, rather than demanding a radical restructuring of the scheme that may bear no relation to financial reality.

Zaki Khorasanee is lecturer in actuarial science at City University, London. Email pension questions to him at soapbox@ thes.co.uk. More on pensions at: www. thesis.co.uk. Universities Superannuation Scheme: www. usshq.co.uk/.

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