Monthly Archives: December 2015

£5 bn of USS’s £8 bn Deficit — Based on Unreliable Forecast

Mike Otsuka ( takes to task USS’s flawed approach to valuation:

USS assumes a rate of inflation that is based on market expectations, as revealed by what people are willing to pay for inflation-indexed versus non-inflation-indexed government bonds. The CEO of USS describes this as an “objective measure” and says that the “trustee takes the view that it is not appropriate to try to ‘second guess’ the economic markets”.

This faith in markets has been shown to be unfounded. Two economists for the Federal Reserve Bank of San Francisco have found “that market-based measures of inflation are poor predictors of future inflation. In particular, they perform much worse than forecasts constructed from survey expectations of future inflation, which incorporate all the information used by professional forecasters. Interestingly, a simple constant inflation rate corresponding to the Federal Reserve’s 2% inflation target consistently performs best.”

These economists maintain that “market participants take a very strong signal from current inflation when forming expectations of future inflation, that is, they appear to simply extrapolate from the current headline rates.” As a consequence, market-based “measures mostly reflect current and past inflation movements, and do not contain a lot of useful forward-looking information. Idiosyncratic market forces and inflation risk premiums appear to be important drivers of market-based inflation expectations.”

If the findings of these two Fed economists carry over to the UK, and the Bank of England’s long term inflation forecast based on their target of 2% CPI is more accurate than market-derived forecasts, then USS’s CPI assumption is much too high. USS says that CPI is 0.8% less than their market-derived RPI forecast. The latter is 3.4%, rising linearly to 3.5% over 20 years. Hence USS’s assumed CPI is 2.6%, rising to 2.7% over 20 years.

The Bank of England assumes a greater gap between CPI and RPI of 1.3%. Hence their long-term RPI forecast is 3.3%. That’s not so different from USS’s RPI forecast.

But CPI now has a much greater effect on pensions liabilities than RPI. The latter figures only in the general salary growth assumption. Such growth won’t affect the liabilities much, given the £55,000 salary cap on CRB. CPI, however, affects the revaluation of CRB salaries, the rate at which the £55,000 cap rises, and the rate at which pensions rise in retirement. So if USS is off by 0.6% to 0.7% in their CPI forecast, they are significantly overstating pensions liabilities. USS maintains that a 0.1% change in the RPI assumption changes liabilities by £0.8 billion. If we assume that most of this is due to the effect on CPI, then USS may be overstating liabilities, and hence the deficit, by about £5 billion.

As of March 2015, USS estimates the deficit to stand at £8.3 billion. Much of this deficit would be erased by a more accurate forecast of CPI.