A Few Thoughts on Pensions

Defined Ambition – We Know Zero

The next dispute over the UK Universities Superannuation Scheme is in full swing (the documents for the ongoing consultation with the universities are available here). I’m not keen to involve myself in what has turned into a pretty dysfunctional conversation. But it prompted me to share a few philosophical thoughts I’ve had on pension funds.

The USS dispute is, again, over a valuation. It largely reduces to a dispute over the discount rate. The level of current contributions required to pay future pensions – pension liabilities – depends on the rate at which you discount those liabilities. The scheme’s actuary, under pressure from the regulator, benchmarks the discount rate to the yield on long-term government bonds, gilts, which remains historically low. The fund is tested for its ability to fund its pensions promises off very low-risk assets. In fact, however, it holds a portion of higher-risk ‘growth’ assets – equities that earn a higher rate. Neither the schedule nor the risk of those growth assets matches those of the pensions liabilities. The extent to which the discount rate can be set higher to take account of the growth assets depends on the strength of the covenant – members’ willingness to pay the difference if returns are worse than expected.

Lately this methodology has represented the fund as being in deficit. One result of the last valuation has been a proposal by employers to really hack into the promised benefits. There are also proposed covenant-strengthening measures, and the prospect of introducing contingency into the benefits will surely come up soon. All this will almost certainly trigger industrial action, especially if the union holds to its stance of not accepting any reduction in benefits or higher employee contributions. What justifies this stance is a belief that no measures are necessary, because the deficit doesn’t exist: the valuation methodology is wrong. The position is that the pension promises can be funded from the return on equities. I find this an odd thing for avowed leftists to get so excited and moralising about: their right to suck up big corporate profits (apparently guaranteed to them) rather than financing public spending by buying gilts.

I’m not personally a fan of the valuation methodology used by USS, but for a different reason. The older methodology – the one many in the union would like to return to – based the discount rate on the expected returns on the fund’s investment portfolio, without any benchmarking to the gilt yield. This made future pension promises cheap, but it left out the risk that expectations might be too optimistic. This was deemed to be inconsistent with a legally-protected non-contingent liability. But the current method benchmarks to a policy variable controlled by the Bank of England. The Bank sets its bank rate by buying and selling bonds, thus effectively setting gilt yields. It sets the rate low when it wants to stimulate demand for investment and consumption. DB pension schemes are forced to respond perversely to this policy: they can’t release DB pensions for current consumption, and their investment in equities is limited by the benchmarking to gilt yields. In other words, benchmarking valuation to the gilt yield forces DB pension schemes against the current of central bank policy. Basically a low-rate policy aims at raising the opportunity cost of holding cash rather than investing or consuming. But since DB schemes are very limited in their range of motion, they end up having to pay the cost rather than meeting the policy goal of avoiding it. It’s a bit like imposing a fine for littering while making it impossible for a certain agent not to litter.

It surprises me, however, that so many leftist academics feel so entitled here. They would prefer that the valuation go back to reflecting the return on equities without benchmarking, so that pension guarantees can stay high and required contributions low. If you’re saying that the fund should be valued at its ability to finance pensions off equities rather than gilts, you’re saying that it should finance pensions off equities (unless you’re asking for financial fraud). But what is the return on equities? If you’re a Marxist, the answer is simple: it’s the surplus value extracted from workers – those who work for the firms in which the pension is invested (workers across the whole global portfolio of firms). Many of these workers are in a much worse financial position than USS members. So if promised pensions to USS members are to be funded by a high return on equities, a high return on equities must be guaranteed, and that, in Marxist terms, means guaranteeing the continued exploitation of a large number of workers. One irony here is that a standard way firms boost their stock listings is by raiding their own pension funds.

Even outside a Marxist perspective, a valuation based on the expectation that pensions liabilities will be financed off equities will be to that extent inconsistent with improving worker conditions or climate-change mitigation, insofar as these might have a negative effect on shareholder value. It locks policy out of doing anything that might compromise shareholder value. A leftist can demand that, of course, but not qua leftist, unless this is a type of ‘accelerationism’ – one that just so happens to financially benefit the accelerationist.

Some will reply that they too are workers, trying to mitigate their own exploitation. Maybe so, but as members of a funded pension scheme you are capitalists, and demanding that your capitalist profits remain high to mitigate your own exploitation doesn’t show much solidarity for other workers.

Other leftists demonstrate some pretty surprising preferences in making their demands about the USS valuation. As Mike Otsuka pointed out in the first of his Uehiro lectures, the main reason USS’s DB pensions used to be cheaper is that the pension promise used to be legally weaker. Employers could freeze and reduce benefits if they chose to wind up their part of the scheme. The increase in cost came with the strengthening of the legal protections around DB pensions. There is a strong parallel here, to my mind, with banking regulation. Because banks have a special social function, and because bank deposits are protected, banks should be heavily regulated, with strong capital requirements limiting the number of riskier growth assets they can have on their balance sheet. I feel that those on the moderate left should be generally in favour of financial regulation, whether for banks or for their own pension fund. Demanding that USS slip the net of the regulator in order to fund a cheaper pension puts you on the side of the libertarian derivatives traders.

Demanding that USS funds itself better, within the regulatory framework, is a different story. Better investment, for a funded DB scheme in the current framework, means taking seriously the contingency of the so-called ‘risk free’ interest rate that I mentioned above – that is, hedging against the fluctuations that make gilt yields volatile. In the current reality, better ‘liability-driven investment’ from USS would be a great outcome. But here I’m thinking philosophically: what’s the pension system we should want?

Out of self-interest, as an academic, I would like the probability that academics receive a good pension to be as high as possible. As somebody who has seen my father develop early Alzheimers and my mother struggle with the difficult and frightening financial dilemmas this involves, I would like the state to guarantee a reasonable level of financial security to anyone reaching retirement age – and support for those who have bad luck. As a social democrat, I’m not very comfortable with having my future depend on high corporate profits that often depend on exploitation, rent-seeking, and environmental damage.

What I’d really like is an unfunded, pay-as-you-go, state-sponsored pension to be broadly available up to a high income level. The contributions into the scheme, like National Insurance, could work like an income tax, and the discount rate on future liabilities would be the growth rate of the tax base, which is to say roughly of the economy. Decisions about the allocation of income between the old and the young would be settled through the democratic process at every stage plus laws protecting basic rights. Obviously cashflow would be no issue, since the payer of the pensions would be the state – and surely the pandemic if nothing else has convinced you that the state’s cheques never bounce.

Where’s the social benefit in a funded scheme like USS in the end? Pension funds allocate vast amounts of capital to firms that perform well on the stock market. Whoop de doo. The overheads are enormous, requiring a huge superstructure of richly remunerated fund managers to make investments, communications and compliance teams, actuaries to carry out valuations or dispute valuations (depending on who hires them), investigators to maintain regulatory standards, etc. etc. etc. All of this is a lot for society to pay for the end result of spraying capital across the market index, basically according to posted profits.

With an unfunded PAYG scheme, some of that money could instead go to the Treasury, which could make public investments aiming at fostering real growth rather than just chasing shareholder value. Part of the reformed infrastructure could be a funding system in which financial institutions were motivated, via collateral frameworks, to finance capital development towards sustainable growth. Deprived of the big wash of capital sloshing out of pension funds, firms would have to attract financing either by demonstrating their viability to value investors or by demonstrating their contribution to sustainable growth to state-sponsored financial institutions. The market could be incentivised towards growth with broad benefits rather than shareholder value.

Of course you might believe that what maximises shareholder value is what serves the public purpose. What’s good for General Motors is good for the country. Then you can demand continued high returns on equities and enjoy them guilt-free (perhaps even gilt-free). But I don’t think most of my left-leaning fellow academics think that. They are inclined to put profits over people only in one very limited case, when it comes to a very specific list of profits. On the assumption that rational agents maximise expected lifetime utility, that’s to be expected. But it’s nothing to get politically self-righteous about.

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