Four reasons why Conditional Indexation (CI) is not the answer for USS

The USS has seen significant challenges at successive valuations over recent times. Market conditions are much more favourable now, but that should not distract from the need to work on a more sustainable, robust approach. The current favoured option seems to be CI, which I do not believe goes very far to fix the underlying issues, for the following reasons:

1) It doesn’t change future service cost volatility

By far the most volatile element of cost in USS valuations has been the cost of future benefits (so excluding deficit payments). A move to CI will do nothing to reduce the volatility because contributions will still be paid based on the cost of benefits with full increases, which will work in exactly the same way as it does now.

2) It doesn’t go very far in managing deficit volatility

This change would only apply for new benefits going forward, so past service already built up will be untouched. It will gradually create a “buffer” between the guaranteed level of benefits (with lower increases) and the target benefits (with full increases), that will start to help in managing deficits over time, but this will be slow to have an impact, and doesn’t actually deal with the biggest issue with deficits in the USS, namely how they are shared fairly between institutions, and with members. It is also worth remembering that given the minimum level of increase that must be paid under UK law, the size of the buffer would be smaller than in other countries such as Canada, where they can decide not to pay any increase at all.

3) It may not allow much additional flexibility in investment strategy

One potential benefit of CI would be if it allowed the USS to take an investment strategy with greater risk, targeting a higher return - the “buffer” created by paying for full increases but only guaranteeing a lower level of increase, would mean the scheme could better withstand volatile market values. This may allow the USS to assume higher returns in the valuation calculations, and so reduce the cost of benefits and any deficit (though not the volatility of those relative to that lower level). That is by no means certain, though, and if the “buffer” is used up by poor returns, then you are back to where you started from, until such time as the buffer builds up again.

Perhaps the biggest question here is whether the USS trustee would be happy with a higher risk investment strategy – and this probably depends upon how the benefit promise is structured. If the trustees’ job is to try to deliver the full increase to members, then why would they be happy with any more risk against that objective than they have currently? On the other hand, if they are focussed on the guaranteed level of benefit, then a higher risk strategy could make sense, but in that case, what that means is accepting an increased likelihood that the full increases are not paid. In either case, the Pensions Regulator is likely to only be interested in the guaranteed level of benefits, which in itself may allow the trustee greater freedom.

4) Limiting increases is not the best way to restrict benefits

Ultimately, CI is one way of allowing benefits to be restricted (by not paying such high increases) as a “release valve” when market conditions are unfavourable. There are many ways that benefits could be restricted, and whilst limiting increases is at least simple, it is quite a blunt instrument, not particularly targeted at meeting any particular need, and can create difficulties with undesired cross-subsidies between generations and institutions. Just looking at the recent debate about whether the USS should reinstate benefit levels to pre 2022 levels shows the problems that can arise from deciding what benefit level (in this case the increases) are affordable, based on a point in time valuation.

A more considered approach would look at what benefits USS members need and value, and also where the DB risk taken really does add value, to create a truly modern, more flexible, targeted benefit to deliver for members, with even lower volatility for institutions.

This note covers a lot of complex topics at a very high level – I am always happy to engage with this discussion, and help explain these points in more detail, if that would be helpful.

Paul Hamilton, Partner, Head of HE

Barnett Waddingham LLP