Phantom deficit

July 5, 2018

While negotiations over the future of the Universities Superannuation Scheme continue, our research shows that the USS is more likely to be in surplus than in deficit.

As pointed out by the Pensions Regulator in its 2017 annual funding statement for defined-benefit (DB) pension schemes, at present there is an industry debate on whether historical relationships between gilt yields and returns on other asset classes such as equities still hold true for the future. According to a recently completed working paper by Woon Wong of Cardiff Business School, the relationships no longer hold because gilt yields are driven by factors that are entirely different from those that determine the returns on equities.

In the 1970s and 1980s, inflation was high, which meant that interest rates and the returns on equities were comparable. Since then, however, successful monetary policies and other economic developments have brought stability to prices, resulting in the long-term decline of interest rates. But because the returns on equities are the result of productivity of firms in the real economy, they remain high despite current low interest rates. This finding has profound implications for the valuation of DB schemes, not least for the USS, the DB section of which might have been closed were it not for the strike action earlier this year.

Since gilts are no longer representative of equities, they are not appropriate for the valuation of the liability of a DB scheme. Despite the USS’ repeated denials of using gilts for its valuation, the working paper shows that interest rates explain up to 99.3 per cent of variation of past liabilities between 2011 and 2017.

Although falling interest rates have been suspected as the reason for the USS’ deficits in recent years, it is either difficult to prove it, given the complex valuation methodology, or to argue against it, because the public has been persuaded to accept lower future returns on USS assets without knowing that such a pessimistic outlook is actually unjustified.

Instead of interest rate, the well-established capital asset pricing theory should form the basis of valuation, which suggests a surplus as large as £10 billion for the USS. To appreciate why a sizeable surplus is possible, the assets of the USS have been growing at a considerably higher rate than is estimated by the valuation in recent years. Thus, for example, the deficit identified in 2011 may well have already disappeared a few years ago had the liabilities not been overstated by falling interest rates.

Woon Wong
Reader in financial economics

Huw Dixon
Professor in economics
Cardiff Business School

Frank Sengpiel
Professor of neuroscience
Cardiff University

The working paper is available at

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