From Andrew Smithers, London W8
Published in the FT 14 June, 2023

Martin Wolf is correct when he writes that “reforming the failing pensions system is a priority” for the UK (Opinion, June 12). The essential change is to the economic theory used. To achieve the full benefit, the time horizon of the liabilities needs to be extended for as long as possible. Consensus economic theory holds that the returns on equities and bonds move with the real short-term rate of interest. We have long-term data that falsifies this assumption. The returns on all three classes, equities, bonds and real short-term rates of interest, are independent. The value of pensions’ liabilities should therefore not be assumed to depend on inflation-linked bond yields. The real, and thus inflation-protected, return on equities is substantially higher than the return on bonds. Investing in equities thus reduces the cost of pension funds. They are riskier over 20 years than bonds, but this risk falls sharply over longer time horizons. The longer a pension fund exists, the more it can thus invest in equities and the lower will be the cost of pensions to its members. The lives of companies are uncertain and pension funds for their members cannot thus reap the full benefit of the high long-term returns on equities. Wolf proposes therefore the creation of “collective defined contribution schemes” as a solution, and there may be others. On the reasonable assumption that in future we will employ a similar, or larger, proportion of our population to teach university students, the Universities Superannuation Scheme is such a scheme. It seems clear that the way its liabilities have been valued is based on bad economic theory, and the error is thus neither the fault of the regulator, nor of the staff of the USS. The consequent and mistaken decision on members’ contributions has caused much disruption, seriously damaging the education of many. Reform of the pension system is a priority and university education would be an immediate beneficiary.