So welcome, everyone. My name is Julian Savelescu. I'm the Uehiro chair in practical ethics and welcome to you here.
Our lectures for 2020. The first you hear our lecture is jointly held with the Moral Philosophy Seminar.
And I'll be passing over to Ed and Jeremy in a moment to formally introduce this year's speaker,
Michael Otsuka, who is professor of philosophy, the London School of Economics.
The title of his series is How to Pool Risks Across Generations.
The Case for Collective Pensions. Michael Otsuka the 17th Uehiro lecturer.
Past lecturers have included Geoff McMann, Peter Singer, Frances Kam, Philip Pettit,
Janet Radcliffe Richards, Tim Scanln, Christine Koorsgard, Elizabeth Anderson and Samuel Scheffler.
The lectures were founded in 2004 and have been funded by the Uehrio Foundation on Ethics and Education.
And they're accompanied by the Uehiro series. In Practical Ethics, published by Oxford University Press.
The twenty twenty one lectures will be given by Professor Howard McGarity at Rutgers University, and the timing will depend on the COVID 19 pandemic.
So without further ado, let me hand over to Ed Lamb and Jeremy Fix to introduce today's lecturer and the speaker in more detail.
Thanks very much I'm Ed Lamb the co convenor.
Quote, The Moral Philosophy Seminar, it gives me great pleasure today to introduce Michael Otsuka,
professor of philosophy at the London School of Economics, and he does Mike's work exemplify the virtues of clarity, simplicity and precision.
He has played a significant role in many of the major debates of moral and political philosophy the last 30 years.
More recently, his work has taken a more practical turn, focussing on issues such as risk pooling, insurance and pensions.
His lectures will make the case for collective pensions beginning today with the case for a funded pension with a defined benefit.
Thanks very much, Ed and Julian. So let me.
Put up a slide. OK, so.
Lot to gain by taking us back in time to 1990 or actually the mid 1990s.
So chosen that decade because it's the last of a golden age for defined benefit pension schemes in the United Kingdom.
And we're going to have a look at the books of the valuation of one such scheme in 1996.
And I'm sure that you can guess the scheme will be well known to many people.
It's called USAC University's Superannuation Scheme.
For those of you who aren't completely familiar,
USS consists of the roughly 70 UK universities that were founded from mediaeval times through to the late 1960s,
plus the roughly 70 Oxford and Cambridge colleges. Now, back in 1996, and actually for most of USSR existence,
promised members a pension equal to one 80th of one's final salary for every year of employment in exchange for employer and member contributions.
There is also a guaranteed re-evaluation of one's pension each year by RPI increases in inflation.
Now, that was how the benefit was defined, defined benefit.
The promise was modelled on the pensions provided in the public sector to civil servants and school teachers at the time.
Now the method employed to value the scheme back then was roughly along the lines that funded public sector schemes are valid in the United States.
To this day, and in certain key respects,
this is the method evaluation to which the union now representing the interests of scheme members and their actual
actuarial adviser first actuarial would like you SS to return to at least insofar as current regulations permit.
Now, they've argued that by returning to what they regard as sound actuarial and investment practises of the past.
Can be shown to be possible. Continue to fund the current level of defined benefit promise at a contribution rate far lower than
what both the pensions regulator and the trustee that administers the pension scheme are demanding.
So question, should occupational pension schemes return to these practises of valuing and funding a pension scheme?
That's the question I mean, to set out to address today. I want to leave you in too much suspense.
My answer to the question will be at least a qualified yes.
We should return to these historical practises because I need to say a few words about how a pension scheme is valued.
I'm going to be examining the method of building a pension scheme today.
Well. Going back to 1996, very different time for valuation.
As of 1996, the assets in the pension fund were valued at one hundred and eight percent of the liabilities that had been accrued to date.
Now, this valuation of the assets is greater than the liabilities implied that the scheme was in surplus.
It was also projected that the scheme would be able to continue to make that same one 80th final salary
defined benefit pension promise and each future year at the cost of only 20 percent of salaries.
Well, the question where these reasonable and prudent assumptions grounded in sound methods of valuing pension schemes generally and if they were,
why is USS now proposing that nothing less than an overall contribution,
twice as high 40 percent of salaries will now be sufficient to provide what is actually
a much Janner and A than the one area final salary that was promised in 1996?
Now. To value pensions, liabilities or promises.
The scheme actuary needs to predict what people's final salary will be under the final salary scheme.
How long people will live in retirement. Looking at mortality tables on average.
And what the future rate of inflation would be because from pensions go up by RPI inflation and then with these assumptions,
then the actuary projects the stream of cash flows that would be paid out of the
fund as pensions to scheme members in retirement decades out into the future.
Now. In order to convert the sum of all these future cash flows into a single figure that captures their present value,
what they actually did and and does to this day is discount this sum by the expected rate of return on the assets in the scheme.
This is the so-called discount rate, which is by far the main source of controversy regarding the proper valuation of the pension scheme.
So the higher the expected rate of return on the assets in future years,
the lower the level of assets and pension contributions now needed to fully fund pension promises.
Let's take us back in 1996, screenshot of the photograph of the cover of the valuation document in 1996.
Now, back then. As you can see, the discount rate, the assumed rate of return on investments with eight point five percent per annum.
That was their assessment of the returns learnt estimates that will be achieved
on the scheme's assets per annum on average over the next several decades.
It's also soon that inflation RPI. Back then, re five percent per annum.
Now. Though this will strike you, as I think, very high assumptions, especially the investment return assumption,
these assumptions were actually in line with an actual little bit more true, the more general actuarial practises at the time.
Now, since for a scheme such as USFS, the liabilities pretty much rose and fell with inflation.
What was most relevant was the margin between investment assumption and the inflation assumption.
No, you assessed calculated, smarter margin with three point five percent,
which is to say they assume that the assets would grow by three point five percent each year in real RPI inflation adjusted terms.
RPI plus three point five question. Well, how sound were these assumptions?
Now, in order to answer this question,
we can actually draw now on almost a quarter of a century of actual returns on various types of assets since nineteen ninety six.
Now, on the basis of U.S. assets modelling or simulating or the historical portfolio, it's actually move now to a different portfolio.
But on the basis of their modelling,
it appears that the scheme would in fact have achieved the assumed annualised real return of over three point five percent.
I mean, not quite the nominal return, but they would have got. Three point five percent over RPI, at least, even up to thirty one July 20 20.
If the scheme had remained invested as it was invested back then.
So why then is the scheme now perceived in such financial difficulty?
Well, it mainly comes down to the fact that for its latest valuation just issued for consultation process is proposing a discount rate,
which assumes that the assets in the scheme will actually shrink by two tenths of a percent against RPI each year for the next 30 years,
rather than growing by RPI plus three point five percent.
Now, largely owing to such more pessimistic assumptions, USSA is now calling for a rise in contributions to least 40 percent of salaries,
double what the contributions were in 1996 to find what is, as I mentioned now, a much less generous pension than what was on offer in 1996.
So why is it that the current discount rate is now so much lower than three point five percent over RPI that was assumed in 1996?
Well, there are three reasons, I think. Expected real long term returns on investments are now lower than they were in 1996.
So on USS his most recent best estimates of expected returns on assets, the portfolio into which the scheme was invested,
1996, is expected to grow by a bit less than three percent per annum above RPI over the next 30 years.
Now note that you assess his current best estimates of real returns on equities, property and bonds.
These estimates are therefore not that much less optimistic than they were back in 1996 and prior to the dot com bubble bursting in the early 2000s,
prior to the global financial crisis of 2007 to 2008, and obviously prior to the current coronavirus pandemic,
you would've thought that maybe they would've adjusted more so. But. But the.
Thinking that returns won't be as high as as was thought in 1996 isn't the main reason why the discount rate is now so low.
It just brings it down to three percent above RPI. Well, the second reason is much more significant for the lower discount rate.
Second reason is that the portfolio out of which you assess will fund its defined benefit promises.
Is now much more weighted towards bonds than the historical 1996 portfolio.
Now, like many defined benefit portfolios, back in the 90s, USS was about 80 percent invested in equities.
And that was sort of the investment pattern up until around the global financial crisis.
Now, the portfolio into which U.S. US now plans to invest over the next several decades will actually end up averaging out.
By contrast, two thirds bonds. So USS is shifting out of equities and into bonds.
In spite of the fact that it actually expects equities to outperform UK government bonds by a huge amount, about 5.5 to six percent per annum.
And USS also expects equities stocks and bonds to outperform corporate bonds by about two point seventy five percent over the next 30 years.
And so this shift from equities to bonds significantly reduces the expected returns on the portfolio.
Down from three point oh above RPI.
That remain invested 80 percent in equities to one point to five percent above RPI.
Now, these returns I've been quoting are those that one can expect on average per annum over the long term.
Back in the nineteen nineties, contributions were set on the basis of such just pure best estimate expected returns on the assets.
Now, by contrast, you assess this current valuation and in fact,
all of its valuations from 2008 onwards have set contributions on the basis of more conservative assumptions.
That one will have a significantly greater than 50 percent chance of achieving.
There's a third reason why the discount rate is now so much lower than it was in nineteen ninety six.
Now for the most recent valuation. Contributions have been proposed on the basis of returns that one can expect to
achieve about three quarters of the time instead of roughly 50 percent of the time,
and moving all the way up to no assumptions on the basis of what can be achieved three quarters of the time.
And this is, in fact, how you assess interprets requirement of current regulations from 2008.
Applying from 2008. The 2008 valuation. That the discount rate must, quote, be chosen prudently.
And once we prudently adjust the discount rate,
it soon returns on assets drops from one point to five above RPI to the two tenths of a percent below RPI.
Or CPI plus five percent.
Now, in pensions, contributions are set on the assumption that long term returns on the assets under which they'll be invested will fall short of RPI,
as opposed to this assumption that prevailed in the 90s that returns will exceed RPI by three point five percent.
It really shouldn't come as a surprise. That members and employers are now required to pay much more for a less good defined benefit pension.
The question I want to ask now is. Is there a sound justification for this huge lowering of the discount rate?
Now, to answer this question, we have to ask the following question. So how do we set the discount rate?
What's the appropriate way in which to discount the pensions payment?
Pensions promises many years in the future in order to convert those liabilities into a single present value?
Well, let me just turn to the. Kurt.
A lot of practise of the pensions regulator. It gives us two different methods of selling the discount rate,
which correspond with two very different philosophies about how to set the discount rate.
So the code says that the discount rate must be chosen prudently.
That's the downward adjustment I talked about. Take me an account.
Either the following two things,
either the yield on assets held by the scheme to fund future benefits and the anticipated future investment returns and or.
The market redemption yield on government or high quality, which is to say high quality corporate bonds.
Now, in the 1996 valuation, which I described earlier, you assess fall, the first of the two related approaches say for one crucial difference.
Back then, there was no requirement, as I mentioned, to discount the returns prudently.
Now, accordingly, the USS Discount on the basis of their best estimates of the long term average rate of returns on the various assets in the scheme.
Without this pessimistic adjustment, now, I'm going to argue that US's approach back then was actually the right one,
save for the fact that they didn't make this prudent downward adjustment.
Just add this prudence and and basically USS was following the right approach.
Before I defend. You assess his approach back then.
What I want to do is turn to an influential case grounded in a theory of value from financial economics for adoption of the second approach.
And you can see from my red X, I've not been convinced by the financial economics case for the second approach.
Now, here's the financial economics case.
According this argument, the discounting of pensions liabilities has nothing to do with the return on the assets held in the schemes pension fund.
Rather, irrespective of whether these assets are actually held by the scheme,
what they believe is that the sound measure of the value of the liabilities is return on those financial assets that, quote,
match the liabilities by providing streams of cash flows that match or approximate those of a promise pension
in their magnitude and their duration and the level of certainty that these cash flows will be delivered.
Well, here's a theory behind such a discount rate. Irrespective of how the pension funds invested, whether invested in equities or bonds,
these liability matching securities provide an accurate measure of the value of the liability, which is the promised pension in the following respect.
Anybody should be willing to exchange the pensions payments they had been promised for a portfolio portfolio of financial assets,
which are guaranteed to as higher degree. To produce the promised cash flows.
And these will be bonds of the right temporal duration, long dated bonds.
Bonds also with inflation protection. And also bonds that reflect the credit risk of the employer who's making the pension
promise the risk that that employer may actually not be able to deliver on that promise.
I think the financial economics approach makes a lot of sense.
For the valuation of a pensions promise, understood as the price.
It makes sense to pay to purchase this promise.
From someone, so the financial economics valuation is actually akin to the sorts of valuations with which we're familiar,
such as the valuation of a house where we're trying to ascertain how much money that
property would exchange for if placed on the market or what it would exchange for.
I think it can be shown, however. That a so-called actuarial valuation of a pensions liability is actually very
different from a determination of the market exchange value of that liability.
And in fact, an actuarial valuation, that thing that used to come around every three years now tends to come around over a year,
too, with you assess an actuarial valuation, doesn't actually involve evaluation of the liabilities.
Rather, the purpose of such evaluation is as follows,
it's to determine whether the pensions contributions placed into the scheme to date have been invested in a matter that is,
quote, sufficient and appropriate to make provision for the scheme's liabilities.
And this purpose is captured by a term known as the technical provisions. Now, as it stated in the UK Pensions Act 2004.
I mean, you can find it in other countries as well.
Every scheme is subject to a requirement that it must have sufficient and appropriate assets to cover its technical provisions,
and the scheme's technical origins means the amount required on an actuarial calculation to make provision for the scheme's liabilities.
Stressed the amount required to provide for the liabilities is not necessarily the value market or otherwise of these liabilities.
What I want to turn to you now are two arguments for why the yield of a bond portfolio that matches
the liabilities does not necessarily provide the discount rate for their technical provisions,
as we've just defined it. Here's my first argument.
Now, first, our report begins with the observation that existing and sound regulatory practises typically require that a weaker,
less credit worthy sponsoring employer of a pension scheme needs to put in more
contributions in order to make provision for a given pension promise than a stronger,
more credit worthy sponsoring employer needs to put into the pension fund.
The rationale is pretty obvious. One can allow more credit worthiness bonds to stay.
Or other and stronger and pensions terminology. To put in less by way of contributions now,
because we know that they are more able to put in more contributions later if returns on the assets in which these contributions have invested.
Turnout lower than expected.
But alas, less credit worthy sponsors, pensions, farmers will be worth less to a worker than a more credit worthy sponsors.
Promise of the same pension payments for the simple reason that a worker will be rightly
less certain that he'll end up receiving the full amount of the pension he's been promised.
So a defined benefit pension that Trinity College,
Cambridge promises will be worth worth more than a pension promise of a single employer scheme whose sole sponsor is on the edge of insolvency.
It doesn't follow, however, that Trinity College must be required to put more money into its pension fund than an
employer on the brink of insolvency in order to make sufficient provision for its pensions.
Given the primary objective, the pensions regulations to ensure that the benefits promised to members are paid, the very opposite is true.
Setting the technical revisions as the market exchange value, I mean,
saying how much you have to provide for selling that as a market exchange value of a pensions promise would have the perverse
consequence of requiring Trinity College to put in more money to secure its pensions promise than an employer on the edge of insolvency.
And that's absurd. Nine turned my second argument for why the bond yield of a portfolio that matches the liabilities
doesn't necessarily provide the discount rate for the technical provisions as defined.
Remember, the technical provisions tells us the extent to which one must make provision for pensions
promises by funding them in advance rather than ours and when the promised payments come due.
So the technical provisions is therefore essentially a collateral requirement.
And as my earlier discussion has revealed, it follows the nature of a pensions promise that bonds will provide a closer match
to a better substitute for a pension than other financial assets such as equities.
But as I shall now demonstrate.
It is, however, a fallacy to maintain that the bond like nature of a pension liability gives rise to any requirement to fund it out of matching bonds.
Or, if not that, at least funding it to a level sufficient to purchase these matching bonds.
So here's the moment, a regulated,
defined benefit pension is essentially a non tradable bond issued by means of the trustee, by a corporation to an employee.
The employee issues a bond to you in exchange for contributions.
A corporation may, however,
issue unsecured corporate bounds bonds to their employees that pretty much replicate most of the characteristics of a defined benefit pension.
Moreover, regulatory requirements for unsecured corporate bonds don't extend much beyond provisions to guard against fraud.
Now, since these corporate bonds are unsecured, then any funding or collateral requirements now,
the relative lack of regulation of such corporate bonds renders it difficult to sustain the view that defined benefit
pensions must be funded up to a level sufficient to allow for the purchase of matching bonds to the liabilities.
Because the mere fact that a defined benefit pension involves a bond like promise does not establish that it must be funded to this level.
If it did, then by parity of reasoning,
one would need to insist that a corporation may not issue a bond unless it secures it with assets that match the liability.
They would, however, defeat the point of issuing corporate bonds if one were required to secure them in this manner from the outset.
Since anyone would hardly be able to make use of the revenue from the sale of bonds to invest in anything other than the securing of that very bond.
We could no longer issue a bond to raise money to spend on other things.
Rather, one would have to use up the money from the sale of the bond monies issued to purchase a comparable bond to serve as collateral.
That's absurd. It was therefore a mistake for financial economists to claim that the bond like nature of a pensions promise gives rise to a
requirement that it be secured by means of funding to the level of the value of a liability portfolio of liability matching bonds.
I've shown that financial economics doesn't provide a justification for insisting that the pensions promise must be secured by contributions,
ring fenced in, the fun guarded by a trustee whose level should be set so high that it is possible to
purchase a bond portfolio that comes very close to matching the defined benefit liability.
Question I want to turn to now is the following. Is there, however, a sound regulatory justification?
This is really what the question is about. What about?
Financial economics and their theory of value.
But is there a regulatory justification grounded in sound public policy considerations rather than the theory of value?
For saying that you have to provide for pensions promised up to love.
Well, imagine. And I now turn to this question that we this reframed question, properly framed question about setting the technical divisions.
What I want to do now is present what I take to be the strongest argument.
For the relevance of the yield on the liability matching bond portfolio to the setting of the tactical provisions to the setting the discount rate
for the purpose of determining whether the assets held by the scheme are sufficient to provide for the pensions that have been promised to members.
Now, recall that I mentioned earlier. That strong movement sponsoring employer hire,
the assumed rate of return on the assets by which the regulator will allow them to discount the liabilities.
It's based on a theory that a financially strong employer is more capable and a weaker
employer of underwriting a portfolio of growth assets such as equities stocks and bonds.
That's on account of.
What's called the equity risk premium, that a growth portfolio will have a higher expected return than a government bond portfolio,
where the promise rate of return of a bond portfolio is from a reliable government is regarded as risk free.
The higher expected return. On equities is regarded as the compensation necessary to induce individuals to purchase equities,
given the greater risks involved in holding stocks in comparison with bonds.
No regulator will, however, insensibly. If someone says I want to invest in equities.
Require the sponsors to underwrite this risk. The sponsor will need to demonstrate that they would be able to put more assets into the
pension fund in the event that the returns on growth assets are less good than expected.
Now, a week sponsor who is less able to demonstrate the ability to make good large funding shortfalls,
will actually be required to invest expensively at the outset in financial assets
that run a much less great risk of falling short of covering the pensions promises.
A sponsoring employer who is so weak that they can't demonstrate any ability to make good any shortfall,
even a year or two in the future will be required. Honestly,
it's almost entirely prefund the pension promise at the very outset when they make the promise by investing at the
outset in assets that come close to perfectly matching the pensions liability in their duration and magnitude,
at least putting enough money in the fund at the outset that you can purchase such a portfolio.
A long dated, inflation linked government bonds come closest amongst financial assets.
PARFUM insurance company annuities to perfectly match their pensions liability.
Such a portfolio will approximate the composition of a portfolio that actually matches in insurance companies annuity and therefore a very
weak sponsor will be required at great expense to discount pensions liabilities at something close to the risk free government bond yield.
Now, stronger response is not required to invest in a portfolio bonds that match the liabilities.
They'll be permitted to invest at far less expense in a growth portfolio.
Who's higher returns are expected to cover the promised pensions payments in future years.
They'll be allowed to do so so long as they can demonstrate an ability to underwrite the risks by showing how they'll
deliver on their pensions promises in the event that the returns on these risky assets are less good than expected.
So how much they demonstrate this? Well, here's one way USSS proposed so-called Safe Harbour.
One way of underwriting the risk is showing that in the event that the downside risks of the growth portfolio materialise,
one, we'll still have the wherewithal to purchase a liability matching bond portfolio that has this very high chance.
Of all the promised. That's for this reason, amongst others,
that the regulator pays close attention to the extent to which the assumed rate of return on growth assets held by the scheme,
which is to say the discount rate on growth assets exceeds the risk free rate of government bonds.
A sponsor who holds fewer growth assets in the scheme.
ServiceMaster, whoo, whoo hoo hoo! Has growth assets worth less in the scheme than liability matching assets is
going to need to generate the following that he has resources to make good.
The gap between the lower price of a growth portfolio with higher expected
returns and the higher price of a bond portfolio with a lower expected returns.
Even in the event that this gap grows even larger on account of either a fall in the stock market or a decline in the yield of bonds.
Now, the useful metaphor of USSS chief risk officer is the following.
He's described liability matching bond portfolio as a safe harbour to lock down the assets that must be within affordable reach of the sponsor.
Can't show you a graph. Now.
This graph, two graphs provide a key to understand, maybe the key to understand the difficulty that defined benefit pension schemes.
Are in now, given the focus on the significance of bond yields.
Now, we can see from this graph that back in the mid 90s,
the risk free rate on long dated government bonds was actually a good deal higher than the risk free rate is now, in fact, back in the mid 90s.
The risk free rate on government bonds that match pensions liabilities was so high that even the USS
was heavily invested in equities and assuming a very high eight and a half percent rate of return.
So putting very few assets in at the outset and assuming that it would mostly come through through returns on investment.
USS, nevertheless, had more than enough assets in the fund in 1996 to cover the purchase of liability matching bonds back in 1996, USS.
Was one hundred percent once. One hundred and twenty five percent funded on a solvency basis,
which was pegged to the cost of purchasing a mixture of index-linked and fixed interest
sterling securities that replicated the portfolio of an insurance company's annuity.
So back in 1996, there was plenty of money to spare in the scheme, if you want to move all the way over to a buyout by an insurance company.
Well, at its most recent 2008 valuation. Instead of being one hundred and twenty five percent funded on this buyout solvency basis,
USSR was only 56 percent funded on a solvency basis, which is to say that the assets held in the scheme.
At the 2008 evaluation, they haven't yet figured out the solvency evaluation for 2020 for the 2018 valuation.
It was worth only 30 percent, six percent of the cost of the purchase of this liability matching bond portfolio.
So employers would have to come up with an extra 50 billion.
Mean talk about deficits. 50 billion pounds in 2018 in order to raise enough money to purchase such a liability
matching bond portfolio that replicates the insurance companies annuity portfolio.
Therefore. Unlike in the 1990s and the early 2000s,
when the safe harbour of a liability matching bond portfolio could be purchased in exchange for the assets under the scheme with money to spare.
Today, such a bond portfolio is far beyond the reach of what employers could afford to move to in the short term.
Now, USF doesn't actually require that the employer must to immediately to move to a liability matching bond portfolio.
USSS current requirement is that a safe harbour must be within affordable reach.
In the following respect.
It must be possible to raise sufficient revenues by means that extra contributions of 10 percent of payroll over the next three decades.
In order to enhance a market value of the assets in the portfolio. To a level which makes it possible to purchase a liability matching bond portfolio.
Actually not quite a stringent requirement of the liability matching portfolios.
The bio portfolio. Why are they chosen?
Three decades of an extra 10 percent in contributions.
But the time period of three decades has been chosen because it's been determined that the higher education sector will at least
collectively be in sufficiently strong financial condition to pay such extra contributions for at least the next three decades.
The covenant is strong for at least that long. But bond yields, as you can see from the graph.
Now,
the little the Michael the action portfolio is so expensive that USS would now fall short of being able to purchase a liability matching portfolio,
even with 30 years of Cygnet significant hands contributions. So the question now is, Will?
Does a defined benefit scheme really need, as you assess, insists it does, to be within affordable reach of a liability matching bond portfolio?
Or my a defined benefit scheme prudently fund pensions promises out of a portfolio of
growth assets whose value falls so far short of that of a liability matching portfolio.
That one couldn't afford to purchase such a portfolio even after three decades of an extra 10 percent pensions contributions.
Well, I think the answer is. No.
We don't need the safe harbour. And here's why such a safe harbour is unnecessary.
So long as one builds in a prudent margin. By which to returns on growth outfits.
Might fall short of a best estimate while still covering the costs of promised pensions.
The risks of remaining largely invest in growth assets are minimal for an open,
ongoing cash flow positive scheme with a long investment horizon such as USS.
That's recently been calculated that returns as modest as CPI plus one point two percent, which translates now into RPI plus five tenths of a percent.
That returns only that low. Are all of us needed to fully fund the current U.S. as defined benefit pension promise?
Out of contributions as low as 26 percent of payroll, which is back what we were paying couple of years ago.
You assess his best estimate of returns on his current portfolio, which is now 65 percent weighted towards growth.
Assets are going to be moving towards bonds in the future. You assess as best estimates of returns on its current 65 percent equities and property
portfolio is about CPI plus three point two percent or RPI plus two point five percent.
That's their best guess as to what returns they'll get per annum.
And this is comfortably two percent above the needed return of CPI,
plus one point two percent to fund our current promise at twenty eight percent contributions.
Seems like quite a margin of prudence now. There is, of course, a risk that growth assets will fall.
More than two percent below their expected return and therefore fail to cover the promised pensions.
The question is, Will, how great is this risk? Of falling below the margin of prudence.
Well. Stochastic modelling that you assessors engage in shows the higher risk investments tend to
perform better over the long term and that the probability of loss decreases over time.
And this is represented by many other people. Seems relatively safe.
So long as you can hold. Growth outside of the long term.
Unfortunately, however. The following significant downside risk remains.
As USSR assault also points out, and this is replicate, did another stochastic modelling the punch, the potential size of any loss that occurs?
Increases with time as well. And in particular, the magnitude of the worst possible outcome increases with time.
And moreover, it appears to be a concern regarding such extreme downside risk,
which actually explains the existence of demand for long dated bonds issued by governments and other institutions with excellent credit ratings.
So as. Exley made Smith explain it as being pencil piece, defending the financial economics approach to devaluating pensions liabilities.
The belief, the true belief that it's highly likely in the long term that equities will generate sufficient returns to cover one's liabilities,
quote, manifestly fails to explain why anyone would be prepared to purchase long dated bonds at the market, writes.
If they be sympathised for so much less, I'll have a portfolio of equities as is being proposed.
The key must lie in the unlikely event where the equities fail to be adequate to explain why people purchase bonds.
Although the probability of this event may be small, it bears heavily on the minds of investors as a whole.
Those who buy bonds. And I said, we can see why.
A promise which holds fast when everything else is collapse all around is potentially very valuable.
Moreover. A funded, defined benefit promise is just the sort of thing that one is meant to be able to rely on,
even in adverse circumstances in which everything else is collapsed all around.
So we can see that in the midst of a global pandemic, just giving rise to a record breaking recession and unemployment,
defined benefit pensions promises are still pay on time and in full by private funded pension schemes.
But he's actually made a Smith note. If anyone could synthesise equities into assets that provide the same cash flows, bonds come what may.
More cheaply then nobody would ever purchase long dated bonds. There is, however, clearly high demand for such bonds.
So how do we respond to this challenge? Well. To respond, this sounds when you do the fine we need.
To show. But at least some defined benefit pension schemes.
Are actually in a better position than others to manage the downside risk of equities.
Even though others find it rational to purchase bonds because the downside risks of equities are too great for them to manage.
The explanation has to be that well defined benefit schemes have certain opportunities to manage the
risk of equities that are not widely available and that other people have to resort to bonds to manage.
Well, how might we? So this. Well, here, I think, is how a defined benefit pension scheme can navigate the open seas of equities.
Even when too far from the safe harbour of a liability matching bond, pour in a huge if necessary.
So here's how a scheme can hunker down and ride out the vortex of even a large drop in equities.
So long as the scheme can be foreseen to be cash flow positive for the next several decades, as in the case of USS.
There's actually no need to quickly repair our deficit and funding in order to ensure that pensions are paid as they fall due.
Because these tensions involve many small and predictable payments that stretch several decades in the future.
An ongoing enduring open. Cash flow positive scheme can therefore safely spread out DFC.
Deficit recovery payments over a long period of time.
For example, the three decades or which USSS covenant has been rated strong in spread out deficit,
covering repayments to to make good a funding shortfall over three decades in order to recover from even very large losses without,
in so doing, running the risk of defaulting on the promises of the pensions they promise to pay as they fall to.
Now, it's here that. The multiemployer nature of certain defined benefit schemes such as USS plays a crucial role.
And USS. Hundreds and the institution.
Even if not every single employer can be counted on to be around and financially strong
enough to make deficit recovery payments that are spread out over the next three decades.
The UK higher education sector as a collective can be counted on to endure and remain sufficiently financially solvent for at least that long.
Now, the so-called. Last man standing. Mutuality of USS ensures that there will be this enduring corporate body capable of
making good on debts whose repayments have been amortised over several decades.
Now on the last man standing arrangement, if any one employer in the scheme becomes insolvent.
Responsibility to make good any underfunding, other promises is automatically shared out by the other employers,
spread out amongst them through small increases in their contributions.
Now, this last man standing structure is a form of insurance on the principle spreading of losses in this case from insolvency.
Even the intently amongst the large number of remaining solvent universities.
And this is the insurance of a mutual association which predates the rise of sophisticated financial instruments.
This is a form of insurance through mutualisation that doesn't rely on a transaction
with an outside insurance company or government agency to secure protection,
which is expensive these days, expensively underwritten by a bond portfolio.
But because allows for long term investment in equities and the way of explained the insurance of a
mutual association is now more cost effective than insurance that requires the backing of bonds,
given how low the bond yield is now. The mutuality of the one hundred and forty or so UK universities and Oxbridge colleges
that form the membership of USS provides insurance against the systemic risks.
The fall in the value of their assets as a result of recession, global financial crisis, pandemic or the like.
Now we saw that the insolvency risk.
And I'm seeing some comments in the chat box, things all right?
I mean, I'm seeing a bit of flickering. It's just somebody that's putting a question that I'll call on when we get to the Q&A sessions.
So nothing for you to worry about. OK, thanks, great.
So we saw the insolvency risk and last man standing scheme is spread out geographically in space across all the sponsoring employers.
By contrast, systemic investment risk. I mean investment risk that say systematic.
I mean, when the stock market crashes, it affects everyone.
Can also be spread out. But in this case, rather than is spread out geographically, you can't do that.
I mean, the the stock market affects everyone. We spread out a systemic form,
the stock market across future time slices of the multigenerational collective body that
constitutes a multiemployer scheme to spread out the risks over time rather than over space.
So pensions promises are secured by the ability to make good shortfalls on the
returns on equities to extra contributions spread out over multiple decades.
This method of underwriting investment risk provides an alternative to the requirement to remaining
within this affordable 30 year journey to purchase of a liability matching bond portfolio.
Now, with the insurance underpinning of Matt last man standing,
which Welday financial assets are freed up for constant and long term investment in a manner that seeks higher returns,
rather than being tied down to the need to provide collateral in the form of liability matching bonds to secure the pensions.
Now, this discussion underscores the importance of keeping defined benefit schemes open and cash flow positive for as long as possible.
And the most effective means of keeping defined benefit schemes open for as long
as possible is through multiemployer arrangements that are wide and inclusive.
So although individual employers, even industries will come and go in economy of producers of goods and services is here to stay.
And there is therefore a public policy justification for bringing producers together in large
networks of multiemployer schemes like you assess where they will be stronger together.
To achieve this, this is a regulatory public policy issue,
not a matter of financial economics valuate not a matter of valuation theory to achieve this.
The state should extend tax relief.
Especially, or maybe even only to those occupational pension schemes that enter into salts multiemployer arrangements,
which they would also also facilitate to make sure that everyone can enter into a multiemployer arrangement.
The state should therefore provide an incentive. For firms to engage in such risk pooling for mutual advantage that gives rise to such an enduring
party that it can spread the risks of drops in equity safely over long periods of time.
Even if we. Provide such tax incentives to join together.
Four firms joined together in a multiemployer last man standing arrangements.
There will be some employers who fear that they'll actually end up the last man standing.
And those employers may choose to go it alone, even incorporate cost.
The last man standing arrangement. Because ultimately,
the last solvent employer bears responsibility to deliver all the pensions of the members
of the scheme in the event of the insolvencies of all the other employers in the scheme.
And Trinity College, Cambridge famously did just this when they recently withdrew from USS fairly great expense.
They bought out their liabilities at the very high expense of an insurance company.
I want to draw this lecture to close. By noting a striking feature of the actuarial advice on which Trinity College chose to withdraw.
This is vice identified a move to a liability matching portfolio as actually the major source of risk to the sector as a whole.
The scenario illustrating the existential threat that US as last man standing arrangement might
pose to Trinity involve following the risk of high deficit recovery contributions caused by,
well, a valuation like this one we're seeing now and then and then leading to the closure of defined benefit and then the subsequent
shift of the portfolio towards an expensive liability matching bond portfolio to secure the funding of past pension promises.
The increasing cost of funding this portfolio, Bede's under the scenario of the insolvency of universities,
which then drives up the deficit contributions required of the remaining universities,
which then leads to further insolvencies to the point where Trinity College,
perhaps with also's and maybe a couple other Oxford and Cambridge colleges are left, the last solvent employer standing.
So it's noteworthy that what prompted Trinity College leave the scheme was not, therefore the risk.
The DBE scheme posed by remaining open, well invested primarily in equities and other growth assets.
In fact, the chief financial officer of Cambridge has been making the case for being able to fund the scheme prudently at 26 percent contributions.
Sixty five percent growth assets.
So it wasn't the risk that was the scenario that prompted Trinity College to withdraw of the US s scheme remaining open.
An ongoing funded out of equities, rather,
was a risk of the insolvency of multiple employers caused by the high cost of moving to this liability matching bond portfolio.
Now in their latest valuation document. USS actually confirms Trinity College's fears when they sketch extreme downside
scenarios in which they might call on all employers available income and assets.
These involve circumstances in which USS intervenes to force the sector at great expense to purchase this liability matching bond portfolio.
They force them to do so. I fear that if we don't act now,
they'll reach a point at which even all the available income and assets in the higher education sector are insufficient to cover the great cost.
Such bump of. So you see on the screen, your source writes the following in their latest valuation document.
These scenarios are sufficiently extreme that there's likely to have been institutional
failure of the craft substantial and at the higher occasion they're somewhat chillingly,
they say. Moreover, in these scenarios, the trustees, namely you assess this call on employers assets in these scenarios,
would not necessarily be restrained by the possibility of inflicting additional harm on the higher education sector.
So this passage implies that USS is prepared to destroy the entire UK higher education sector
to ensure that defined benefit pensions promises laid down in the past are paid in full.
Well, let's grant, if only for the sake of argument,
that expensive investment in a liability matching bond popular is the most effective means of securing pensions,
promises have been laid down in past years.
We can also accept as a matter of current legal fact, that's a primary duty of the regulator to secure such past promises.
Nevertheless, the justification of such a duty involves normative considerations of public policy.
Such a duty does not follow from any truths. In financial economics regarding the proper method of evaluating a defined benefit pension liability.
Moreover, there cannot be a sound public policy, just a.
So much weight on the securing of past pensions promises even at such high cost,
that destroys the ability of those sponsors to lay down any future pensions promises,
including to the very same workers they promised pensions in the past while also threatening the very solvency of such employers.
For a large multi employer scheme with a strong covenant whose horizons is long, there's no sound case.
The requirement to fund pensions promises against the benchmark of a liability matching bond portfolio.
Such a scheme can instead be funded prudently on the basis of the higher returns on equities that are expected.
It's only through the enactment of regulations and tax incentives, which will give rise to more such multiemployer schemes,
that we'll be able to provide affordable, secure, funded pensions for people in their retirement.
So schemes such as USS ought to be viewed as a model.
Rather than a cautionary tale, it ought to be regarded as the solution rather than a problem.
Thank you very much.