USS swings into surplus but flags re-think after Thames losses

The £74.8 billion University Superannuation Scheme (USS) has reported a funding surplus for the first time since 2008, with chief executive officer of USSIM, Simon Pilcher, saying one of the benefits of higher interest rates was it is cheaper to hedge the scheme’s liabilities.

“We took advantage of this opportunity, thus reducing our exposure to interest rates and inflation, which means the scheme is better protected should bond yields fall again,” he says in the USS annual report.

The investor’s 2023 actuarial valuation revealed a scheme surplus of £7.4 billion, allowing lower contributions and the restoration of benefits to pre-April 2022 levels in a turnaround marking the end of one of the toughest period on record for the DB pension scheme.

Less positively, the report also detailed how USS’s losses in troubled utility Thames Water has led to a “serious reflection” on investment in regulated assets in the future. This at a time the UK government is trying to persuade pension funds to invest more in local infrastructure.

“Economically regulated assets should be a good fit for long-term patient investors like USS, particularly where, as with infrastructure, they require long-term investment to address historical challenges,” said Simon Pilcher.

However, he noted that success is dependent on similarly long-term, consistent regulation that recognises the need for that investment and strikes a fair balance between risk and returns over the long term.

“While our overall experience of investing in private markets has been beneficial, we seek to learn the lessons of all our investments – whatever the outcome. Our experience with Thames Water will influence our future approach to investing both in economically regulated assets and more broadly.”

USS remains a shareholder in Thames Water but said that the value of the holding was now “minimal.” Two years ago its stake was valued at £956 million. Further revealing the scale of the losses, he said that since USS first invested in Thames Water in 2017, any profits that might otherwise have been used to pay shareholder dividends were reinvested into the business. “We have not received any dividends or payments of interest on any shareholder loans,” he said.

USS was not alone in this investment with fellow pension funds from around the world experiencing big losses including the Dutch PFZW and BCI and OMERS from Canada (OMERS wrote down its entire 31.7 per cent holding). See Thames Water losses hold lessons on the importance of a comparative view.

Despite losses in Thames Water, USS said private markets as a whole have delivered strong returns to the scheme over an extended period.  Over 10 years to the end of March 2024, infrastructure assets have delivered annual returns in excess of 11 per cent. During the past year the fund exited a number of private investments, generally at favourable prices to where they had previously been marked in its books. New acquisitions included growth-focused private equity, long duration income-generating property assets, and inflation-linked assets like renewables.

Pilcher said that returns across growth assets were generally positive particularly in the US driven by AI-fulled tech stocks. He said the outlook for equities was reasonable, and stated that bond markets are also likely to deliver solid returns now that yields have risen.

The pension fund flagged key risks from climate change and biodiversity loss, geopolitical tensions and the demographic time bomb where fewer people of working age must support rising numbers of retired people. USS employs tools like horizon scanning, scenario planning, diversification, and stress-testing as critical elements to help build a resilient portfolio and respond effectively to events as they unfold.

A developed markets equities team now manages a new £4 billion allocation to a long-term real return mandate designed to provide strong long-term returns at lower levels of risk than the wider equity market. Responsible investment has been built into every stage of the investment process for this mandate. Moreover the low-carbon emissions of the companies owned in the mandate supports the investor’s ambition for investments to be net zero by 2050 meanwhile the concentrated nature of the mandate allows it to hone in on stewardship activities.

Climate planning

USS  has developed four new scenarios in conjunction with Exeter University to better reflect the real-world risks and opportunities that frame climate investment and systemic risk decision making over the short and medium term. The analysis switches the focus away from climate pathways and allows USS to pay close attention to shorter-term changes to politics, markets and extreme weather events when assessing the long-term financial impacts of climate change.

“We took the decision to make this research publicly available for other investors because the real-world impact of climate change could be much greater than previous modelling has suggested. We hope this work will be of benefit to many others and help galvanise real-world action as people understand the costs of inaction associated with the current trajectory towards ever higher temperatures.”

The emissions intensity of the the scheme’s corporate investments is now 39 per cent lower than in 2019 and over half of the reduction seen in 2023 is a result of the  new LTRR equities mandate because the high-quality companies owned in this mandate typically have a very low emissions intensity.

Still the report does flag concerns raised following analysis of the scheme’s investment and advisory performance that covers factors from quantitative risk and return metrics, to qualitative inputs, flagging poorer performance in active management and private markets.