The University Superannuation Scheme could breach funding triggers relating to the size of its deficit, as coronavirus continues to cause turmoil in markets.
The £72.9bn scheme launched a consultation on its 2020 valuation on Monday, including proposals for a new approach to employer covenant assessments, a dual discount rate for valuing accrued and future benefits, and a departure from the controversial ‘Test 1’ risk mechanism.
But wild swings in asset values, caused by an oil price war and fears of the impact of coronavirus, mean that under terms set by its previous 2018 valuation the fund may be forced to consider derisking measures.
We have to be clear that the employers are willing to underpin such an investment strategy with their future cash flows, which will need to take the place of the anticipated pension returns if they don’t materialise
Bill Galvin, USS
The USS’s trustee board is required to consider an appropriate response if, consistently over five days, the scheme’s self-sufficiency deficit represents more than 85 per cent of the present value of 10 per cent of its sponsors’ payroll over 30 years.
In a letter to employers, the scheme warned that it only escaped this trigger event last week on the fifth day of the test, with a proportion of 84.6 per cent.
Concluding that while volatility control strategies have helped, breaching the trigger is a likely outcome as market chaos continues, trustee chair David Eastwood and chief executive Bill Galvin warned that possible reactions from the scheme include “an accelerated valuation, a request for higher contributions sooner than October 2021, an acceleration of the ‘derisking’ path envisaged under the 2018 valuation, or a combination of the above”.
Scheme takes smoothed view of returns
“I expect that we will reach that formal trigger before March 31, given the financial conditions that we’re experiencing now,” Mr Galvin told reporters on Tuesday, but assured that the trustees take a long-term view of expected returns.
“Our methodology has never been one in which we take a simplistic response based on the return on gilts or interest rates in general, but it’s always been, at every valuation, to take a fundamental look at the prospects for return on different asset classes.”
Regulations also allow the scheme to take account of events over the course of the valuation process, effectively smoothing some volatility.
Nonetheless, the threat of forced derisking comes at a tricky time for the USS, when pressure from striking academics has forced employers to consider ways of letting asset returns do more heavy lifting.
Talks over the principles for its 2020 valuation have led to proposals that are designed to enable some re-risking of the scheme’s investment strategy and less strain on employer and member contributions in funding future service.
This split between past and future would be achieved via a dual discount rate, allowing for more investment risk in the future service strategy.
If employers agree to a rule change on leaving the scheme, alongside debt monitoring and further issuance resulting in increased scheme security, the “negative watch” could be removed from PwC’s rating of the covenant as “strong”.
Another proposal would remove Test 1, which checks that the difference between self-sufficiency and technical provisions in 20 years’ time is not greater than employers’ stated risk appetite. A new “check” would allow greater flexibility, according to the consultation proposals.
Speaking to reporters on Tuesday, Mr Galvin said that for any increase in risk-taking, “we have to be clear that the employers are willing to underpin such an investment strategy with their future cash flows, which will need to take the place of the anticipated pension returns if they don’t materialise”.
UCU unmoved on pro-risk stance
If the market impact of coronavirus or the oil price war turns out to be more sustained, employers and striking members would therefore have to fund a resulting shortfall.
However, University and College Union negotiator Sam Marsh echoed Mr Galvin’s assertion that the new valuation should not be overly sensitive to such wild swings, pointing to the open scheme’s long time horizons.
“Market volatility that isn’t directly traceable to fundamentals shouldn’t harm the scheme in the long term,” he said.
“It is unclear how much of an effect current market movements will have on the USS in the long term, but any valuation methodology that is oversensitive to short-term movements cannot be a sound basis for decision-making.”
Coronavirus shocks DB deficit by £100bn in a week
Market turmoil stoked by fears of the Covid-19 outbreak has added £100bn to the UK’s defined benefit deficit in a week, according to Hymans Robertson analysis.
He continued: “Recent market movements aside, on many measures the scheme has been strengthening in recent years: we’re not seeing a widening of deficits on a technical provisions basis. In fact, basing the valuation on prudently adjusted returns on the current portfolio, there’s a large surplus (£6.8bn as at December 31).”
However, Dr Marsh was less supportive about the proposed replacement for Test 1, saying the two mechanisms did not look substantially different.
“Their new approach appears to rely on a ‘Test 1, version 2’, which is unlikely to satisfy those who wanted a proper rethink,” he said.
