Last September the Pensions Regulator sent a letter to Sir David Eastwood, chair of the Universities Superannuation Scheme (USS).
The letter reprimanded the scheme and him for apparently not being upfront about the scheme’s liabilities and also questioned plans for dealing with its presently assessed liabilities.
It was a badly judged intervention by the regulator.
It seemed that despite big growth in its assets, the USS - the biggest pension fund in the UK with £60 billion of assets - had seen its liabilities grow at an even faster rate.
You could say that the USS was trying to steer a prudent and practical course through some pretty stormy financial waters.
The Pensions Regulator didn’t like that course, though, and put his foot down.
A more considered reading of the altercation suggests, instead, that the real problem is a regulator pretty much in denial and unable to recognise a wider crisis.
In fact, we’d argue that the regulator should stand up for pensioners, businesses and the taxpayer, or resign. Here’s why.
The crisis has actually been exacerbated by the regulator’s office itself failing to take action on what is one of the most pressing – albeit under-reported - issues in modern British economic life: allowing the discount rate for UK pension funds to fall precipitously.
Specifically, the regulator has allowed them to fall to very low levels in the context of a wider market where interest rates and bond yields have fallen.
And quantitative easing (QE) was also ignored by the regulator as having a big impact on discount rates.
Why does this matter?
The discount rate is one of the final pieces of the jigsaw when a valuation is made of the health of a pension fund. It’s designed to calculate (for some purposes) the ultimate figure for liabilities of a fund.
The first big number before the discount rate is applied is how much the total figure is that the fund is obliged to pay out to every member from that day and into the future, until everyone in that scheme that day is dead.
The challenge here is that this is future money, or rather future liabilities. So, those valuing pension schemes have to take into account the value of that future liability figure in today’s money.
And the standard way to do this is to apply a calculation, a rate, to these future liabilities. It’s called the ‘Discount Rate’. Perhaps counter-intuitively, though, the lower the discount rate, the higher become the judged liabilities in today’s money. And vice versa.
As the former interim chief executive of Carillion said to the Joint Business and Pensions Committee last month: “Each time the discount rate falls by 1 per cent it adds £600 million to our pension fund deficit.” The pension fund issue was a big factor in Carillion going bust.
For the USS in particular, discount rates have halved in the matter of a few years as market gilt yields have catastrophically - for pension funds at least - fallen with QE.
In 2008 the scheme had a surplus of £700 million and was 103 per cent funded. It had a normal discount rate of 6.4 per cent. By 2013 its discount rate was 4.8%.
With gilts yields plummeting to around 1.5 per cent last year, the initial discount rate used by USS and others to assess liabilities fell as low as 3.2 per cent.
So the calculations put the scheme at just 83 per cent funded and with a deficit of £12.6 billion, which really was nonsense, economically.
Index-linked gilts were actually giving negative yields (as much as -0.09%) in the market place from 2014-17, which was effectively a double whammy to many pension funds.
This resulted in such a crazy set of calculations that the USS then had to come up with another method for discounting its liabilities based on the actual spread of investments and by choosing a range of different discount rates.
But they shouldn’t have had to do this. The regulator should have acted years ago.
So a big issue here is not the failure of the USS to take prompt action (it has in fact, repeatedly), rather it’s the fact that the regulator’s office itself has failed to protect pensioners of the USS (the biggest pension fund in Britain) as well as many other UK private and public pension schemes.
The regulator has left it to the funds themselves to ensure they are taking advice from their actuaries about the discount rate applied and the wider interest rate environment.
Rather, the regulator should have given forward guidance to pensions actuaries about adjusting what their training has told them to do in the context of a post global financial crisis world where QE has depressed interest rates and bond yields.
Previously used formulae and rates simply no longer apply in the economic and political world as currently operating. Certainly the regulator should have thought of this.
The Pensions Regulator could and should advise caution to pensions actuaries in using current rates and formulae (especially the implied Discount Rate) emanating from the current QE-induced artificial market.
A floor has already been put on Discount Rates elsewhere in Europe – that’s what should have happened here, especially as soon as QE started in the UK and United States.
As the Governor of the Bank of England, Mark Carney, said just last month: “These are interest rate cycles unlike those experienced in the past… in past rate cycles the average rate was 5 per cent and since all the way back to the founding of the Bank of England in 1694 rates also average around 5 per cent.”
We would suggest a discount rate floor at an appropriate rate of at least 2 per cent above that, at 7 per cent as a floor now.
In other words, the regulator should regulate. Then we might have a more realistic view of what liabilities are and whether there really are such substantial ‘deficits’ in pension schemes including the USS.
Perhaps the USS could itself lead the way. Its chair is a modern historian with economic history to the fore. A long view of history should prevail, we’d argue.
John Clancy is a pensions analyst and former Leader of Birmingham City Council. David Bailey is a professor of industry at the Aston Business School in Birmingham.