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Joseph Mariathasan: Are LDI valuations right for an entity like USS?

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The strike by academic staff at UK universities over changes to the Universities Superannuation Scheme (USS) is clearly damaging for students and it is a sad state of affairs that other means of discussion were not able to resolve the issues.

USS is the UK’s largest pension scheme and the issues it faces are reflective of the issues faced by any still open defined benefit pension schemes. In the case of the USS, there is another factor to bear in mind, which is that universities are public entities and indeed, staff at newer universities are on a different scheme.

One of the key issues in the debate is how much risk the fund should take and indeed, how that risk should be measured. Liabilities are priced off the back of Gilt yields that are themselves artificially depressed through quantitative easing, while the risk management approach of liability-driven investment (LDI) forces the purchase of Gilts irrespective of price.

Assuming such low yields will persist forever and that pension funds need to be able to fund liabilities on that basis is the reason why defined benefit transfers have become so attractive for some individuals. Some schemes have been offering transferees multiples in the region of 40 times projected annual pension income. For those willing to take capital risk – which clearly may not suit everyone – the income yield on a diversified portfolio including equities would easily beat yields of 2% available on 30-year Gilts.

But what may be suitable for some individuals seems impossible for a fund, even though the fund has a much longer time horizon. But should open defined benefit pension schemes be so concerned about mark-to-market capital fluctuations if there is no intention to close the scheme down?

Some would argue that LDI-driven fixation on purchasing sovereign debt irrespective of the price is a form of financial repression. The driving forces have been a mixture of accounting changes, regulatory issues and the underlying movement towards treating LDI as a purely risk management problem. These have set in stone the present values of pension liabilities based on government bond yields that we know will change each year.

The net result is that matching pension liabilities is seen as a risk management issue rather than an investment issue, so pricing of debt has become irrelevant. Pension funds are therefore unable to invest in long-term risky assets, whether in the UK or overseas, despite having long-term liabilities.

But the ultimate risk taker in a country is the state itself. There is a case to be made for setting up a UK sovereign wealth fund financed by issuing Gilts sold to UK pension funds. This would, in effect, be acting as an intermediary guaranteeing pension funds the ability to meet their liabilities whilst generating much higher cashflows from elsewhere.

The House of Commons debated the idea in December 2016. One of the briefing papers for the debate was an article I wrote in 2012 for IPE. In the article, I had suggested that given an aging population, the UK should set up a sovereign wealth fund to add to tier one pension provisions. As MPs pointed out in the debate, there is an issue of inter-generational justice when it comes to allocating resources within a country. An increasing aging population cannot expect to solely rely on the Ponzi-type economics of taxing a declining younger population for future pensions.

Investing a sovereign wealth fund in emerging market equities, for example, with many funds currently offering yields well in excess of 4% and even 5% in some cases, would easily cover the cost of the Gilt coupons while receiving dividends produced by younger populations outside the UK.

A sovereign wealth fund may have some benefits for the USS. More issuance of Gilts will push yields up a bit, thereby reducing liabilities and the deficit. But perhaps the real issue is a political decision on whether LDI valuations are appropriate for a public sector entity.

 

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