Collective defined contribution has been touted as a possible long-term solution to the problems of the Universities Superannuation Scheme, but experts and unions are not convinced of its suitability.

As Pensions Expert has reported previously, the USS trustee has been locked in protracted negotiations with employers, represented by Universities UK, and union members, represented by the University and College Union, over the outcome of its controversial 2020 consultation.

The results of its latest valuation saw the scheme’s deficit quadrupling to more than £14bn, requiring that contributions be raised to between 30.7 per cent and 42.1 per cent of payroll under the most favourable scenarios. However, unless employers agree to a series of conditions, the rates could be increased to as much as 56.2 per cent of payroll.

UUK has been consulting on alternative proposals, which include stronger covenant support measures and a 20-year moratorium on scheme exits, that it hopes will produce a more favourable outcome than the hiked contribution rates that employers and unions have branded “unaffordable”.

UCU, meanwhile, is preparing for strike action following a ballot conducted earlier this month, though will have to re-ballot a number of institutions that did not pass the 50 per cent threshold required for them to join in industrial action.

Is CDC the answer?

Writing on Sunday, Martin Wolf, associate editor and chief economics commentator at the Financial Times, reiterated several of the criticisms previously levelled against the conduct of the 2020 valuation and the methodology underlying it, and advocated CDC as a long-term solution.

He criticised what he called “unduly risk-averse decision-making” at the USS, in particular its “prudent return” assumption of 0 per cent over the next 30 years, which is worse even than the outcomes following “two world wars and the great depression”.

The level of prudence adopted was criticised early on by Aon and has since been attacked by both UCU and two university professors, Dr Neil Davies, senior research fellow at the Bristol Medical School, and Dr Ewan McGaughey, senior lecturer at King’s College London, who are bringing legal action against USS directors.

The latter argued that, in conducting the 2020 valuation, the directors failed to take account of “relevant considerations”, such as the timing of the valuation — at the “low point of the Covid-19 stock market crash” — and the fact that the methodology “assumed there would be 0 per cent growth in assets for 30 years above [consumer price index] inflation”.

“There has been, in reality, around 30 per cent growth in assets above inflation in the 18 months since the valuation date (March 31 2020). However, the USS directors forced proposals to cut the pension based on these projections, when there is in fact likely to be a multibillion surplus,” they said.

In a press briefing, UUK attempted to counter calls for a new valuation on the basis that there would be no substantial improvement, asset recovery being counterbalanced by changes to future service rates, though this did not stop UCU writing to universities demanding they back a second valuation.

Wolf acknowledged the counterpoint raised by Imperial College professor of financial economics David Miles and professor of economics James Sefton that, even if returns on equity are mean reverting, there is a 23 per cent chance that the USS would run out of money by 2100.

“What does make sense is to have a sensibly invested fund (that is, one predominantly in equities) that is structured in ways that limit the downside risk to both members and sponsors in the event of things going wrong, on a relatively manageable scale,” he wrote.

“What would then be needed is some adjustment of benefits and contributions. This flexibility is what all pension funds need, not to protect themselves against extreme disasters, but against the downsides of actual performance in the real world.

“In a sensibly managed CDC scheme, that would happen. Since the sponsors of the USS do not have infinitely deep pockets, it makes sense for the liabilities they bear to be capped,” Wolf added.

CDC cannot replace past DB promises

Matthew Arends, partner and head of UK retirement policy at Aon, told Pensions Expert that the key issue with defined benefit scheme investing “is that it is done in the context of needing to meet commitments to pay pensions to members”.

“That commitment to pay is underwritten by the sponsoring employer(s) and UK pensions law means that the survival of the pension scheme takes a higher priority than the survival of the employer. And if the employer fails, then only reduced benefits are payable to scheme members via the Pension Protection Fund,” he said.

“Consequently, DB pension schemes invest with a degree of caution to protect their ability to meet pension commitments. But lower risk assets typically deliver lower returns, which in turn drives a higher cost of delivering the benefits.”

CDC, by contrast, removes benefit guarantees as benefits are adjusted in line with financial performance, Arends explained.

“The absence of guarantees enables more investment freedom and consequently permits much greater investment in return-seeking benefits. And if scheme assets perform well, that positive performance will be reflected in members’ benefits, not in contribution holidays,” he said.

Barnett Waddingham partner Danny Wilding acknowledged that the ability of CDC schemes to take more investment risk constitutes a significant advantage over DB arrangements.

“If this higher-risk strategy pays off over time then it could be possible for the USS to deliver its target benefits at a lower cost and so make it easier to balance reasonable benefits with affordable contributions,” he said.

“But if the investment performance doesn’t arrive then member benefits will need to be cut back — there will be no responsibility for the employers to top up the CDC fund. Members will need to understand they are taking on this risk.”

Wilding added that CDC “can only replace future DB pension promises. The past DB promises cannot be switched to CDC under the current pension regulations (except for any members who might choose this option)”.

“That issue has been debated in the past and the argument to allow conversion to CDC was lost. This means that the issue of funding the past USS DB pension promises will continue to dominate the scheme’s finances for the foreseeable future irrespective of any change made for future pension accrual,” he said.

What about conditional indexation?

A UCU spokesperson told Pensions Expert that “there are a number of actions employers should be considering to stop huge cuts to member pensions”.

“Instead, they are pushing through cuts of 35 per cent to guaranteed benefits and forcing staff to take strike action on campuses across the UK. While CDC pool risk between members of a scheme, they still place all the risk with members and not with employers,” they said.

“The only alternative to the current arrangement which UCU members have indicated they would be open to exploring is conditional indexation,” they said, arguing that this option “could lead to lower contributions and/or higher benefits than the status quo, but it would take time to implement and UCU members would need to be confident that it would be superior to the current arrangements”.

“Conditional indexation will not provide an immediate solution to our dispute with employers. The only way that can happen is for employers to withdraw their cuts and work with us to protect defined benefits and prevent staff being priced out of the scheme,” the spokesperson added.

 

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