Don’t give up on USS?

The 3-yearly actuarial valuation of the USS is currently underway, which will set the contributions that employers need to pay into the scheme to fund future benefits and also pay towards the deficit. More detail of how this works was covered in our webinar from last year. Whilst this webinar was some time ago, it did predict that the deficit, whilst large, would not be the biggest problem – instead the main issue is cost of future benefits.

The cost of providing pensions increased for two main reasons:

1) Increases in life expectancy. If we retire at the same age and live longer, it costs more to provide the same level of pension.

2) Lower expected future investment returns. If you get a lower investment return in the future, then to get the same out of a pension scheme, you have to put more in to make up for the reduced return.

The trickiest part is that we do not know for sure what will happen in the future – and remember, when looking at pension schemes, we talk about what might happen to people who are now in their 30s and 40s, when they are in their 90s (and beyond) – so we really do have to look a long way forwards. Will people really keep living longer over that timeframe? I don’t know, but I wouldn’t like to bet against it. Will we really have lower investment returns in the future? It is impossible to say for sure, but the limited information we have to go on at the moment suggests that is the more likely outcome.

To compound this issue, defined benefit (DB) pensions (like the majority of the benefits in the USS) come with significant statutory guarantees. These mean that if you have a challenging target, you have to provide it, even if things go against you, so employers must plan for bad outcomes when considering the cost of such pensions. It is very difficult to provide a lower guaranteed benefit, but target a higher one (if things work out well) under the current regulatory framework for DB benefits.

The first issue is that pensions are costing more, which means you have to either pay more in or get less out - and there is no way around that.

Meeting UUK’s test of not diverting money from other core activities results in getting less out, meaning some combination of:

- Having a lower starting pension

- Retiring later (so your pension is paid for a shorter period)

- Not receiving as high annual increases to your pension (so you get the same amount at outset, but relatively less later in retirement)

That last option – reduced pension increases - is worth looking at in more detail because:

- The increases are very expensive making up around one-third of the cost, giving significant scope for saving, without affecting the headline pension amounts staff receive.

- Generally, staff do not understand how costly increases are. The value they place on the increases may not equate with the cost of providing them - does everyone need the same purchasing power in their 80s and 90s as they had in their 60s and 70s?

From an employer value for money point of view, the increases are therefore not very cost effective. Removing the increases would create a more affordable and better targeted use of resources. Therefore to reduce cost, I think the first place to look is the increases – the big problem here is that it is a statutory requirement for DB schemes to provide pension increases (albeit not quite to the level that the USS does).

To compound the issue, pension increases cost even more when people are living longer and investment returns are lower (because these are both about increased cost to pensions further away – where the increases have the biggest impact).

There are basically three ways that increases could be removed, if that were the desired solution:

1) Move to DC (as proposed). The flexibility to shape income to suit needs in retirement is one of the key benefits of DC relative to DB.

2) Government intervention to remove the statutory increase requirement

3) Move to a “cash balance” type of pension scheme

It is hard to see the Government changing legislation given the needs of just one pension scheme, so, other than the proposed move to DC, that just leaves the cash-balance option.

A cash balance scheme is like a DB scheme until the member retires and provides a pot of money at retirement based on a formula (how long you have worked, and what your salary has been, like in a DB scheme). However, the pension that is provided is more like that from a DC scheme – the employee uses that pot of money to purchase a pension in the form they would like and all the standard DC flexibilities would apply.

In the absence of a change to legislation, a cash balance arrangement would offer a more affordable way to target contributions to employees’ needs, whilst still giving some guarantees around the level of benefit they would receive.

Fundamentally, any scheme which offers some guarantees over the level of benefits will have uncertain costs. Cash balance schemes do provide guarantees, so that uncertainty would remain, albeit at a much lower level than with the current USS benefits. Universities are unsurprisingly keen to have stable costs and an attempt was made at the last actuarial valuation to look at how to minimise the risk of increasing contributions above 18% in the future. The problem with that, of course, is that however small the risk of higher costs, it can still happen (as we have seen!).

The only way to have certainty around the cost is to move to a DC scheme as proposed. You then get complete certainty for the employers over the cost of future benefits (but not deficit contributions). The risk instead falls on members who will get lower pensions at times when pensions cost more, as the employer will no longer be topping them up if needed. A middle ground of cash balance could significantly reduce the volatility, but would not eliminate it altogether.

The deficit has become bigger over the 3 years to the valuation date (exactly how much depends upon how you measure it) and this trend could continue, having said that - it could also reverse. One thing for the employers to beware of is, if the USS moves fully to a DC basis, then the USS trustees are likely to focus even more on protecting the past DB benefits. This could lead to a more prudent approach being taken and/or shorter recovery periods at future valuations – leading again to an increased demand for contributions towards the deficit in the future.