The financial market collapse at the start of 2020 was, on the face of it, a disaster for the world’s pension funds. The value of stocks and some bonds worth trillions of pounds plummeted as the extent and depth of the global recession caused by Covid lockdowns became clear. The UK’s biggest private pension scheme, the Universities Superannuation Scheme (USS), was no different: the custodian of the retirement savings of 470,000 university and college workers lost billions of pounds. At its latest valuation, actuaries came up with an alarming conclusion: the assets of USS were only worth £67bn, leaving a huge deficit of £18bn compared to the liabilities it has promised to pay out in the future. Yet the recovery was almost as extraordinary as the decline. Central banks pumped money into the economy, and tech companies in the US recorded astonishing gains. That helped USS assets back to more than £90bn at the end of January. That recovery – and the controversial question of how the fund accounts for it – has put USS at the centre of a row that could result in university staff occupying picket lines across the country. The scheme will also be at the centre of a legal battle this month, with academics asking a court for permission to sue directors for not performing their duties. USS members come from more than 330 institutions, including the universities of Oxford, Cambridge, Manchester and Birmingham. Among them are some of the country’s best economists – and they are putting their knowledge to use in the tussle with the trustees. All of which adds to the challenges faced by USS and its chief executive Bill Galvin. “Clearly it’s regrettable that employers and unions are finding it difficult to agree the way forward right now,” Galvin told the Observer, sitting in the USS offices next door to the Bank of England in the City of London, where the meeting rooms are all named after universities. The situation has been “pretty unavoidable” for the fund, he said, caught between regulatory requirements to cover the technical deficit and the subsequent increase in the value of those assets, which lowers the expectations for future returns. The employers and the trustees argue that they have no choice but to address the deficit by raising pension contributions for academics (many of whom are not particularly well paid), even at a time when the UK is grappling with a cost of living crisis. At the same time, the benefits members receive in retirement will also be cut. The University and College Union, which represents the staff, has put forward new proposals under which universities would contribute more and not cut retirement benefits, with the threat of strikes at 68 universities if talks fail. Hanging over it all is an important philosophical question on the approach to risk taken by pension funds. Ewan McGaughey, a reader in law at King’s College London, is among the claimants taking USS to court on 28 February to try to overturn a ruling that they do not have standing to sue. He argues that USS is making “absolutely indefensible assumptions” on its future returns. The academics’ case cites a USS technical paper that shows a 0% real return once inflation is taken into account. USS said it could not comment on ongoing legal proceedings. Professor Raghavendra Rau of the Cambridge Judge Business School argued that there is no precedent since at least 1900 – covering “two world wars, the great depression and the 1970s oil shock” – for such pessimism. Martin Wolf, the economic commentator at the Financial Times, has likened the USS approach to preparing for nuclear war (an observation that provoked weary laughs in USS’s offices). Yet it is not simply a case of academics on one side and the USS managers on the other. In a paper published in September, David Miles, professor of economics at Imperial College London and a former Bank of England monetary policymaker, and James Sefton, also an Imperial economics professor, argued that the risk of USS having insufficient funds to pay promised pensions was between 20% and 40%. Simon Pilcher, chief executive of USS Investment Management, is in charge of choosing the actual investments. “Sadly, one can’t project the past into the future,” he said. “Today, we think it is reasonable to expect lower returns going forward than we’ve experienced in the past, because it’s those higher returns that have driven us to these high prices.” USS’s view was that “we’re not obviously in a materially better position today”, but they were trying to be “prudent, rather than recklessly prudent”, Pilcher added – although the deficit had “shrunk” by an undisclosed amount. Galvin argues that the scheme has little choice because the Pensions Regulator (TPR) is “already slightly outside of its comfort zone” on what it will allow. “We certainly have taken the Pensions Regulator to a level where it believes that we’re taking as much risk as they believe we should,” said Galvin. “They believe, indeed, that we should be charging even slightly more, 1% to 2% more” for the employees’ pension contributions than is being proposed. The row reflects a deeper shift in who bears the risk of retirement income across the British economy. The classic pension model pools employees’ savings, paying out a defined benefit for as long as that person lives. However, rising life expectancy has made it harder for pensions to cover longer retirements, so many employers have moved to “defined contribution” pensions, which only give the benefit of whatever has been paid in (plus returns from the investments). That has shifted the risk to workers. USS is a hybrid, but will move further towards the defined contribution end if the employers and managers get their way. Galvin acknowledged it was “less generous”, but argued that “there is still a substantial amount of defined benefit”. Indeed, the 200,000 active USS members account for more than a fifth of the fewer than 1 million people in the UK who are still able to pay into defined benefit schemes. Pensions are always deeply concerned with existential matters: the more people who die early, the easier it is to meet their obligations. The climate crisis has added another dimension to this concern for the people managing the money. Now fund managers must weigh the probabilities of mass planet-wide death in a climate catastrophe, too. On this issue USS is also facing serious pressure from its highly educated members – a membership that happens to include some of the world’s leading experts on climate science. A campaign group, Divest USS, has pushed for the scheme to sell its shares in fossil fuel companies for several years. USS has tried to assuage academics’ concerns on the environment, including in a decision last month to “tilt” equities worth £5bn away from the worst polluters, cutting emissions of that part (albeit a relatively small one) of its portfolio by 30%. It has a formal target of net zero emissions from its portfolio companies by 2050 or sooner if possible. Yet Pilcher is clear that USS will not “exclude its way to net zero”, even as major counterparts such as Dutch pension fund ABP or Harvard University have done so. That suggests USS could continue to hold investments in oil companies such as BP and Shell for years to come, despite warnings from respected authorities that fossil fuel extraction needs to stop now. “Long-term capital such as ourselves needs to facilitate the change and the enormous investment that’s required for us as a country and as a globe to get to net zero,” Pilcher said. However, he argued that it would also be the “best investment strategy for our members” to “oversee the transition of businesses for the financial benefit of our members” – a nod to the uncomfortable fact that some fossil fuel businesses are likely to continue to offer financial returns for years. That argument could be tested in court. McGaughey, the claimant, said USS was “ignoring the members, ignoring the science, ignoring what is financial orthodoxy now”, that fossil fuel firms are likely to underperform broader markets. Even if USS can settle the row over the pension deficit in the next few months, those questions could dog the scheme for decades to come. The plunge into private equity One striking aspect of the Universities Superannuation Scheme’s investment approach is its enthusiastic embrace of the racy world of private equity investment. USS has direct ownership stakes in big infrastructure companies such as Heathrow Airport, the Moto motorway service stations, and Thames Water, the utility covering much of south-east England. This puts the scheme in an interesting position. While most pensions are invested in stocks and shares, USS is one of relatively few British pension managers putting the savings of low- and middle-income earners directly into private equity-style deals. Huge sections of the UK’s everyday economy, from Boots to Butlin’s, are now in private hands. Since the start of the pandemic, 1,200 companies worth more than £90bn have been acquired in private equity deals, in a shift which has seen big names such as the supermarket chain Morrisons depart the London Stock Exchange. Often, the dividends and profits of these businesses are shared only among those wealthy enough to afford the high upfront cost of investing in private equity funds. USS goes some way to redressing that imbalance. At the latest count, 28% of its assets were in private markets – including property, private equity and private fixed-income – across its vast portfolio. That includes £6.2bn of direct private equity investments (at March 2021 values) and direct loans to companies, including some from its £500m L1 Renewables arm, as well as investments in standard private equity funds run by giant firms such as TPG and CVC. Simon Pilcher, USS’s investment boss, said that he expected the proportion of private market assets to rise, potentially offering the scheme better returns. He also argues that pension funds such as USS make better owners than many private equity investors, who often extract value before selling companies on after about five years. Pension funds could, in theory, be willing to stick around for decades. Thames Water is a good example of where USS can be different, Pilcher believes. Previous owner Macquarie, the Australian investment bank, was condemned by critics during its period of ownership for allegedly aggressive value extraction, but USS is willing to make investments that will pay off slowly. Its representatives on Thames Water’s board successfully argued against paying a dividend in favour of making investments in its network or repairing leaks, Pilcher said. Spending to prevent universally reviled practices such as dumping sewage in rivers would eventually lead to better financial returns, he added. “We think of that as responsible capitalism,” he said. “We are the natural owners of an asset like that for the long term.” JJ