How solemn is the USS’ league of covenanters?

Members of the Universities Superannuation Scheme are about to vote on whether to lock in current members. But this might not be enough to safeguard the scheme’s solvency, says Bernard Casey

April 29, 2020
covenant

By 1 May, member institutions of UK universities’ Universities Superannuation Scheme (USS) will have to vote on whether they wish to formally bar any more of their number from leaving the scheme.

Plans for such a vote were already under way before the coronavirus pandemic put a further spanner in the works. The intention had been to protect the “covenant” – a feature of the USS that, in the eyes of many, makes it inviolate and, therefore, not subject to the same strictures from regulators as might apply to other schemes that run deficits of a similar size.

But Covid-19 certainly accelerated the USS’ actions. In mid-April, it issued a further “rationale” for action. The covenant, which represents the backing that members (“sponsoring employers”) could give to support the scheme through difficulties, would be weakened if those who were asset-rich were to leave. The USS had been looking over its shoulder at what had happened with Trinity College, Cambridge – widely regarded as “the last man standing” – which decided a year ago that its financial situation would be strengthened if it did not have to carry the contingent responsibility of supporting the USS.

Why the concern with the covenant? The scheme saw a fall in its assets of some 12 per cent in the first three months of 2020, while its liabilities are unlikely to have diminished – despite massive increases in government borrowing, the bond rates determining how these are discounted have scarcely moved. Did the USS believe that Trinity’s action would be contagious?

In its “rationale”, the USS suggested that there were many institutions that could afford to pay the so-called “Section 75 payments” that clear their obligations. Most of these appeared to be individual Oxford and Cambridge colleges. Hence, there were pleas for them, in particular, not to jump ship. Two “research-based” institutions were also considered well able to afford to leave. They were not named, but who they are is pretty obvious.

The USS is a voluntary association. USS sponsors joined it for their advantage, and, just as for any other club, they have the right to leave if membership no longer serves them. What they understood about the workings of a multi-employer plan when they joined the USS is difficult to fathom, and this aspect was not mentioned in the one authoritative history of the scheme’s founding at the beginning of the 1970s. Yes, the rule book did permit for rule changes to be made at the proposal of representative employers and members, but this permission was very general. Those who were faced with being blocked from leaving might feel at least as short-changed as members of open-ended investment funds who thought they could take their money out at will but who, like investors in Neil Woodford’s funds, found poor performance resulted in a moratorium on payouts and ended up losing shedloads of money (in fact, rules for such funds are much more explicit, and investors in them are more “experienced” than the institutions who signed up to the USS).

Breach of the covenant by leaving the scheme is seen to have serious implications. If more institutions followed Trinity’s lead, it would increase liabilities because a lower discount rate would have to be employed. Even to keep the USS on the path it wishes to follow, contribution rates would have to go up further. This is what all parties wish to avoid – all the more so in current circumstances.

However, trying to shut stable doors to prevent horses from bolting misses the point. PwC, which the USS employed to assess its strengths and weaknesses, described the covenant as “strong”, but also “on negative watch due to the risks of increased debt levels and strong employers exiting”. What PwC failed to comment on was another “strong” component of the scheme, “positioning of employers in the UK and global education market”. But Covid-19 has severely threatened the position of UK universities, along with those in countries, such as the US and Australia, that have been heavily dependent on high-paying foreign students. Even in the USS’ “rationale” document, this evokes barely a phrase.

What is really to be feared is a fall in the credit rating of the sector as a whole. In the past, some USS sponsors have had their status downgraded by Moody’s or S&P for overspending (especially on facilities) and overestimating student numbers. Some of the largest sponsors – research-intensive universities – are likely to find themselves in difficulties and downgraded because of their reliance on overseas (and especially Chinese) students. Examples include UCL, Imperial College London and the University of Manchester. Institutions such as these – which tend to have recognised credit ratings – are likely to be downgraded. They might not have been one of the last men standing, and they might not have been able to afford Section 75 payments, but their weaker position will dramatically affect the overall covenant.

Difficult decisions are unavoidable. The current remit of negotiators in the USS’ Joint Negotiating Committee, and the members of the Joint Expert Panel, established in 2018 after industrial action by academics over the threat of reduced benefits, has been to find ways to stay increases in contributions.

There have been proposals to remove “Test 1”, adopted by the scheme in 2014 to ensure that it remains within an agreed comfort zone of investment risk. However, this would encourage more “risky” investments. There have also been proposals to move to a “dual discount rate” – something to which the Pension Regulator makes no reference at all and that has the magic effect of making a sum of money worth one thing if looked at from one side and something else if looked at from the other.

It is time the negotiators’ remit became much wider – to look at the overall generosity of the defined benefits it promises, and at alternative models of risk sharing. Failing this, there might be no system left that is worth saving.

Bernard H. Casey is a retired USS member who also worked for the Organisation for Economic Cooperation and Development. He now runs a consultancy, SOCialECONomicRESearch, in Frankfurt and London.

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Reader's comments (1)

Dr Casey has been banging on about the USS for many years. He makes the same points obsessively with monotonous regularity and often using inflammatory language. First, the USS has not been “running a deficit” as he suggests. The scheme makes a large annual surplus from its investment portfolio and contributions which exceed pensions in payment. Last year its investments earned around £1.8 billion in dividends, interest, rent etc (not counting capital gains), pensions in payment were around £2 billion, and contributions from members £2.2 billion. The issue between USS and its members concerns how the distant future of the defined benefit scheme (for most members on salaries below £60k) is seen. It all depends on the method you use to find the present value of future pensions liabilities. It is this nuanced discussion about financial economics that Casey is sensationalizing. If the USS is seen as having to be managed in such a way that it can close to new members at any moment, then there could be a shortfall if investment earnings are very poor or university staff don't join up in such numbers. (Though they will not find a better deal than a DB pension.) On the other hand, if the scheme is valued assuming it stays open indefinitely, as a vital part of the HE system in the UK, with strong employer support, then it can invest its annual surplus to gain high returns in the long term, matching its pension liabilities, and there will be no shortfall. The biggest threat to the survival of the scheme is actually the ‘deficit’ - the asset-liability shortfall calculated assuming it will have to ‘derisk’ its investments towards low earning government bonds. The best and most efficient thing to do is to manage it as an open ongoing scheme, build up investments (and of course decarbonize). The main reason that people like Casey say the scheme (and other DB schemes) is in deficit is because of the blindly dogmatic way they value the pension liabilities. That has been the cause of all the pension scheme closures in the last ten years or so. That is due to the government’s Quantitative Easing policy with their setting of extremely low interest rates. There is no objective, or market value, for pension liabilities. That one needs to be conjured up, using a DCF formula, under the legally required statutory funding objective is the problem. It’s not the poor performance of the investments, which will do well enough provided we remain a capitalist economy. He mentions removing “Test 1 that was adopted in 2004 to ensure that it remains within an agreed comfort zone of investment risk”. Once again he is misleading. In truth Test 1 is being removed because it is based on a huge mathematical error that was pointed out by UCU negotiators. The real issue is whether the USS goes ahead with its notorious ‘derisking’ strategy of deliberately investing in bonds that are expected to lose money rather than equities that have a positive but more variable return. Derisking does not reduce risk except under extreme prudence. The USS crisis is of national significance and crucial to the future of British universities and in the present circumstances of the coronavirus requires government oversight, as does the state of universities. More than that, it is about the provision of pensions for future generations, something that is being ignored by present government policy. It is not simply a matter of the application of microeconomics of risk and return in a theoretical model.

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