The USS Deficit

Currently in the UK there are three main types of pension scheme.

The basic State pension, and many pensions for state employees, are underwritten by taxation. If the income they receive from current workers is not sufficient to pay pensioners, the Exchequer makes up the difference, and there is no investment fund backing them. Whilst the pension schemes of the Civil Service, of schools, and of the newer Universities operate like this, the USS does not.

The majority of private pension schemes are now `defined contribution' (DC) schemes. A defined amount of money is placed into an investment fund, and, on retirement, one receives whatever that fund is worth, with no guarantees. Such schemes can never be in deficit.

Finally there are defined benefit (DB) schemes. These specify one's pension, usually in terms of final, or some form of average, salary. Whilst in work money is put into an investment fund, but in retirement one's pension is guaranteed, no matter what the performance of the fund. If the fund underperforms the employer has to top it up, and, if it overperforms, the pensioners are unlikely to see any benefit. These schemes used to be very common, and the USS is such a scheme.

The Valuation Problem

Final salary schemes are very difficult to fund correctly as promotions shortly before retirement can be very expensive for them. Fortunately the USS is no longer such a scheme.

Career average salary schemes remove that difficulty, but still need to balance future liabilities, based on projections about future life expectancy, against future investment income from their funds. Recently life expectancies have been rising, and investment returns, particularly on bonds, falling, making DB schemes more expensive.

Neither the liabilities, nor the future investment returns, can be calculated precisely, so best estimates are produced, along with some prudent, but pessimistic, estimates of what would happen if life expectancies rise faster than expected, or investments perform poorly.

A major issue for the USS is the size of the difference between the "best estimate" and "prudent" valuations. In 2017 the best estimate was that it needed assets of £55bn, but the prudent estimate was that assets of £68bn were required. Actual assets were £60bn.

If the prudent estimate is correct, there are then concerns about where £8bn could come from. According to Wikipedia, excluding Oxbridge only one UK University has an endowment of over £250m, and the total endowment of the non-Oxbridge Universities is about £3bn.

But this might not matter. Given the near monopoly the pre-92 Universities enjoy over an important part of the economy and of society, and that most of their income is effectively from the State, even if they have little in reserves, their income stream is fairly reliable.

By 2021 the actual assets had risen to £81bn, but the liabilities had risen to £96bn. The main reason for the increased deficit was an increasingly pessimistic assumption about the different between bond yields and future inflation, caused in part by the Covid pandemic.

What is clear is that the USS assets, which are approaching £100bn, are very significantly bigger than the assets of the employers. Even a small percentage deficit could be quite alarming.

This creates a problem for the valuation. As soon as there is the slightest possibility that the returns on investments might produce a deficit that the employers would struggle to pay, the "natural" response is that the USS should move its investments to things which produce a more certain return. However, removing risk from an investment portfolio inevitably reduces the expected rate of return too. This then makes a deficit more likely.

The same issue arises in personal investments. Money that one certainly needs must be invested in something boringly risk-free, doubtless yielding a low return too. If one is fortunate enough to have more money than one needs, the excess can be used to buy riskier investments. If one is unlucky, one might lose it all, but it was only excess money anyway. On average, one will move from being rich to very rich, receiving rates of return it would be imprudent for the less wealthy to pursue.

The manner in which the USS Trustee predicts future investment returns has nothing to do with the past performance of the USS's investments. Sometimes people criticise its investment managers. I see no evidence that they are underperforming. Rather, the Trustee does not recognise their skill. Sam Marsh of Sheffield University has written an interesting article on the USS's extreme prudence.