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The Nerdy, Contentious, and Existential Debate Raging Inside One of Britain’s Biggest Funds
The Universities Superannuation Scheme is pushing further into private markets. Some of its pensioners are not happy about it.
Simon Pilcher, the first person in his family to go to university, was halfway through a degree in geology and metallurgy at Trinity Hall, Cambridge, before he realized that he wasn’t cut out for a life of academia — and switched into management studies.
“I’m not an intellectual,” he tells Institutional Investor from his house in leafy North West Essex, where he and his wife and four of their five adult children are sheltering and competing for the broadband.
“No, I’m not an academic,” he repeats. “But I like knowing a little about a lot.”
Pilcher has plenty to get his head around as the new chief executive of the investment arm of the Universities Superannuation Scheme, the U.K.’s biggest pension fund by assets, with about £73 billion ($91 billion) under management. Pilcher is in charge of the future livelihoods of almost all of the country’s academics working at U.K. universities established before 1992.
Unfortunately, he enters into the relationship at a moment when it has almost completely broken down.
USS was set up in 1975 to fund university professors in retirement. It maintained largely the same structure until 2011, when, under pressure from the financial crisis, final salary pensions were scrapped. Since then each valuation of the fund’s assets, carried out under the law every three years by trustees, has brought more headaches and the threat of strike action from university staff.
The central debate is a tangled knot of mind-boggling mathematics and competing investment ideologies. It centers on whether or not USS — a hybrid scheme with both defined-benefit and defined-contribution elements — should look at its investment strategy on a liability basis. On one side, actuaries claim that years of investing in equities have blown a £6 billion–size hole in the USS balance sheet. On the other, the academics say it doesn’t really matter — just as long as USS can pay its pensions when they are due.
And both sides are furious.
Pilcher is at pains to stress that it is not his job to intervene in the debate. Instead, he says, he must simply meet the objectives set out for him by trustees. Nonetheless, despite the good performance of the fund’s equity portfolio over the past five years, Pilcher has dismantled the stock-picking team and started to beef up investment capabilities in the private sphere, a move away from the fund’s heavy reliance on public markets — even though the current fund allocation has delivered returns of more than 10 percent over the five years to March 2019.
“We said, ‘Let’s stop doing what we have been doing and start doing it differently,’” Pilcher says. “It was a logical connection that, our track record is fine, but it wasn’t an area that I had conviction that we could develop strong benefits to the scheme going forwards.”
While the battle rages over the future of the fund, his argument is that private markets are the place where it can add the most value. And Pilcher is making the bet with billions of dollars’ worth of pen-sions from hundreds of thousands of academics, many of whom are watching closely.
Can he pull it off?
When it was first introduced on April 1, 1975, USS was set up as a balance-of-cost scheme in which members paid a fixed contribution and employers agreed to pay the balance. It was also constructed as a “last man standing” multiemployer scheme, meaning that if an employer collapsed, the others would bear its responsibilities to its pensioners.
In effect, a default would require the bankruptcy of every institution and the collapse of the entire U.K. university and research community — not a likely proposition in 1975, when higher education was heavily subsidized by the state.
But successive U.K. governments have eroded subsidies for universities, a process that accelerated when Prime Minister David Cameron took office in 2010. By allowing universities to triple the cap on tuition fees, he forced institutions to compete by setting their own rates and shifting the burden of funding education onto students, who became consumers in the new market arrangement. It was the end of an arc toward privatization that had begun with Margaret Thatcher removing state incentives for overseas students in 1980, when Cameron was still a few years off his Bullingdon Club days at Oxford University. The move tripled foreign students’ fees overnight, forcing universities to start thinking about what students wanted, rather than simply choosing from a queue of applicants.
In 2011 the balance-of-costs element was scrapped, making both members and their sponsors — the universities — liable for extra contributions needed to meet promised pensions when they were due. Under these changes, members of the University and College Union — which represents 120,000 staff, from casual researchers to permanent lecturers — expect to pay on average £40,000 more into their pensions and receive £200,000 less in retirement. Within a decade some universities have plugged millions into marketing, as pay and conditions for those who teach have eroded. Even before the havoc wreaked by the pandemic, nearly one in four universities had declared a deficit. From September, universities say they will face a £2.6 billion shortfall — half of which will come from the loss of international students unable or unwilling to study overseas — leaving three quarters of universities in a critical financial position, according to an analysis by London Economics for the University and College Union.
But it was the 2017 valuation that really broke things.
Faced with a funding deficit of £7.5 billion, meaning the scheme was 89 percent funded, Universities U.K., the body representing university employers, proposed scrapping defined benefits. It rescinded the proposal a few short months later, in April 2018, after a massive strike action in which universities across the U.K. ground to a halt. But the damage was done. Thousands of academics now had their eyes on the valuation. Just how was it calculated? Why were they being forced to pay it down with their livelihoods? The scrutiny has continued to escalate since October 2019, when USS fired Jane Hutton, a medical statistician at Warwick University, from her position as the union-nominated non-executive director of USS after she blew the whistle on the fund, claiming the deficit valuation was wrong. Her employment tribunal is ongoing.
Now staff await more information on their contributions in the 2020 valuation, due to be published this summer, at a moment when the higher-education sector faces fundamental questions about its future — not least: Once you have turned the student into a consumer, what happens when you can no longer deliver the promised service?
Enter Simon Pilcher, renaissance man, 30 years of fixed-income under his belt and not a single day running a pension fund.
After earning his degree at Trinity Hall — ironically one of the most memorable colleges to depart from USS in 2019 — Pilcher spent a total of nine years in fixed-income at Morgan Grenfell before being plucked to become head of fixed-income at M&G at what he now describes as “a scarily young age. I had a happy 20 years at M&G; I never dreamed at the outset that it would be such an interesting job, and I certainly didn’t plan on becoming a chief executive for a pension fund.”
Nonetheless, when Roger Gray, his predecessor at USS, contacted him in 2019 to come for a chat to ask if he would be interested in stepping into his shoes, his “feet moved very quickly,” as Pilcher told a roomful of academics at the USS Institutions Meeting, a kind of annual general meeting, two months into the job. He explains to II, “To be responsible for the largest pension fund in the U.K., and to be a market leader in private markets, was very appealing.”
Uniquely, Pilcher has also worked for a church in the City of London. He took a two-year stint at the church on Bishopsgate in the City of London from 1993 to 1995, in the middle of his years at Morgan Grenfell. Pilcher revealed in a 2016 interview that his faith gives him a cool head in moments of crisis. He recalled a moment during the financial crisis, when banks were failing, his savings and his pension were about to go up in smoke, and a member of his financials team at M&G turned to him and said: “Simon, I don’t get you because you understand where this could end up and you’re not panicking.”
Pilcher replied: “My status is not wrapped up in my running a bunch of money. My status is that I’m a much loved son of Christ, and I have a great future with him. We may all be farming mung beans at home tomorrow, but my status is not wrapped up in what I’m doing here.”
Nonetheless, he sees the potential of a fund the size of USS to act as a lever to achieve worldly things. “Private markets enable us to have a closer relationship with the management [of firms] and to seek to influence the management so that they take actions that we think are good for the longer term,” Pilcher says.
In June, USS announced that it will pull investments from sectors it deems “financially unsuitable” in the long run, including tobacco manufacturing, thermal coal, and controversial weapons such as cluster munitions. “Companies that are dumping carbon into the atmosphere, or cancer into people, will ultimately pay the price for that,” Pilcher says. “That will come either as consumer preference [changes] or as regulations tighten — therefore we should position the portfolio in light of that.”
Where USS holds shares, it has also shown a willingness to intervene. At the AGM of Royal Dutch Shell, USS worked with other institutions as part of the Climate Action 100+ to force Shell to adopt commitments to come closer to the goals set in the Paris Accord. “If it’s a publicly quoted company, we won’t have quite the same level of influence,” Pilcher says. “But we worked with a number of other institutions to influence Royal Dutch Shell, for instance. That’s an area where we can use our muscle to influence the way in which one company operates for the benefit of society.”
But not just society, he adds: “We think there is an illiquidity premium or higher returns that we earn for the scheme for accepting less tradable positions in companies.”
It’s the less tradable part that has members worried. “How do we know that the prices they are paying are reasonable?” asks Dr. Neil Davies, professor at Bristol University and a UCU and USS member. “The big problem that we have is transparency. If they are making investments on behalf of us and getting things wrong, it’s very difficult for us to spot that. It’s doubly difficult if it’s a private market investment.”
Pilcher is hardly the first pension fund chief executive to eye private markets for superior returns. In fact, at USS his appointment might be seen as the culmination of a strategy that began in the aftermath of the 2008 financial crisis.
Mike Powell, head of the private markets group at USS, declared in 2008 that USS’s long-term aspiration was to follow the model of the Canadian and U.S. pension funds making direct investments in companies worth $100 million to $1 billion while trying to lower the fees it paid to private equity managers. “We are relatively unique among U.K. pension schemes choosing this path, but we’re not really a trailblazer in terms of the global pension funds investing directly into infrastructure,” Powell said, tipping his hat to the “groundbreaking” Ontario Teachers’ Pension Plan for pioneering the more direct approach.
At this time, Powell described the fund’s experience with private equity–like funds as “disappointing,” saying USS had invested in the wrong type of assets, at the wrong price and with the wrong capital structure. “We took the view that the only way that we could control our exposure was to start buying assets ourselves,” he said. By copying the strategy of funds on the other side of the Atlantic, Powell added, he hoped for “second-mover advantage. They did it first, and we can learn from their experience.”
In Pilcher, Powell finds a head of investment who speaks the language of private markets. At M&G, Pilcher oversaw the growth of investments in private and illiquid assets as institutional investors struggled against years of low interest rates and quantitative easing following the global financial crisis. M&G was one of the first nonbank investors in European leveraged loans in 1999 and, from 2009, became active in direct lending, stepping in when capital-constrained banks were unable to do as much corporate lending.
As chief executive of M&G’s fixed-income and alternatives business, Pilcher managed $161 billion of assets, ranging from asset-backed securities to bonds to project infrastructure finance and private equity. From 2018 he was also executive chairman for global operations at M&G Real Estate, which had $41.1 billion in assets globally by December 2018. On the real estate side, he oversaw a team of asset managers that sourced two thirds of its assets off-market. Two months after his departure, trading in the M&G Property Portfolio was suspended following close to £1 billion of withdrawals over 12 months. Managers blamed “Brexit-related uncertainty” — a grave warning of the challenges of property assets that Pilcher had barely escaped having to learn.
Pilcher left M&G in what he calls “a mutual decision for me to leave management,” during a shake-up of its senior team when it split from Prudential — a merger that had lasted barely two years. At USS he spent a couple of months getting acquainted with pension funds. “I’m the poacher-turned-gamekeeper,” he says. “At M&G I had clients who were pension funds. Now I’m the client. I need to learn to think like a gamekeeper.”
Both of Pilcher’s predecessors shared a similar view of the strategic vision of USS.
Peter Moon was at the helm for the 17 years leading up to the financial crash of 2008, at which point USS was 80 percent invested in U.K. and overseas equities, 10 percent in property, and another 10 percent in government bonds. When markets crashed in 2008, the scheme lost 27 percent of its value and continued to shrink until March 2009.
Gray claims he could “still smell the smoke” when he entered the building on September 1, 2009. He overhauled the portfolio, reducing its exposure to the U.K. and focusing on emerging markets and private assets. But he shunned the trend toward liability-driven investing. “Pure liability-hedging assets, such as index-linked gilts, tend to be — and currently are — very expensive,” he said in 2010. “We’re not going down the liability-hedging route as aggressively as some others.” Ten years later he said that not making a bigger push into liability-driven investing was his biggest regret.
Pilcher now faces a choice: Buy assets that delivers precise cash flow and perfect matching for interest rate and inflation risk. Or, faced with 400,000 members in the top 1 percent for life expectancy in the country, secure assets that would sacrifice liquidity for better long-term returns. Reflecting on Gray’s major regret, Pilcher says: “Will we continue to buy instruments that give us inflation protection? Yes. But ideally, I’d like to give us a higher return than you get from an index-linked gilt.”
When coronavirus hit, Pilcher had to transition the team to work-from-home at the same time he was grappling with a market meltdown on the “challenging” Wi-Fi service in his “very, very rural area.”
He started by ensuring that USS had enough cash and collateral to operate smoothly, especially in positions held via derivatives.
“Obviously, the market value of equities fell quite significantly,” he notes. “But what we saw in the fixed-income markets was massive outperformance, particularly our U.S. fixed-income assets, that gave us opportunities to book profits on some of those and to reinvest them back into the U.K., taking assets out of government bonds and into corporates.”
In February, Pilcher had been in the middle of overhauling USS’s equity division, closing its entire developed-market equities team, worth £14 billion, despite the team’s strong performance. He says the team of 13 has mostly been redeployed, and the money is going into quantitative and “responsible investment” divisions.
Pilcher saw gaps that needed filling in fixed-income and private markets. To take care of the former, Roger Gray, perhaps mindful that he had overlooked liability-driven strategies during his tenure, had already hired Ben Clissold as head of fixed-income and treasury management away from BlackRock, where he specialized in liability-driven strategies. Clissold joined in January 2020, a few months into Pilcher’s appointment, and has since been hiring staff in credit, corporate bonds, fund management, and credit analysis to deepen USS’s personnel in liability-driven investing. “His market expertise proved invaluable as we navigated the fairly challenging March and early April,” Pilcher says.
Pilcher is now on the hunt for a head of strategic equity to build out the private markets team. The new hire will be in charge of finding equity investments that will give USS a better hedge for its liabilities than just owning the stock. Pilcher wants someone to spot longer-term trends, such as the move away from physical retail toward online shopping, which he sees as a “multidecade trend, and the sort of trend that we should be looking to embed in our portfolio.”
The private markets portfolio, established in 2007, had grown to £17 billion within the first decade. It comprises 320 assets, including infrastructure, property, private debt, and private equity, from Sydney’s Airport Link to the U.K.’s National Air Traffic Control Services to Heathrow Airport. In June it emerged that USS has reportedly been bidding for a stake in G-Network, an ultrafast broadband provider that delivers high-speed internet services across the U.K. A spokesperson declined to comment.
Private markets come with their own challenges in moments of market upheaval. During coronavirus, Pilcher says, USS has worked closely with the companies in which it invests, including providing a cash liquidity facility so some could continue to trade. It also offered rent holidays for mom-and-pop owners of businesses and other types of real estate, and looked at debt financing deals for local governments.
Meanwhile, Pilcher has moved to plug even more into these sorts of assets by opening up the private markets portfolio to members of USS’s defined-contribution scheme, not long after that fund hit £1 billion. He says he wants to grow exposure to private markets over three years, from 25 percent of the fund currently to 35 percent. “The reality is it takes a long time to build private debt or a private equity portfolio,” Pilcher explains. “USS has been at this a dozen or more years. This is something that we have over 50 people focused on, and you can’t build a portfolio that size overnight.”
It’s a mission that the endowments of some large U.S. universities, led by Dave Swensen at Yale, started several decades earlier. In the 1980s, university endowments began to shift their allocations into private assets. As well as allowing for longer-term investments, private equity funds gave investors leverage, assisting in the pursuit of higher returns. When markets took a nose-dive, endowments were supposedly protected from the downside, as they were held in illiquid private funds with longer-dated maturities. In such arrangements fund managers could — and still do — exercise some discretion over the way the assets are valued.
Recently, long-term studies appear to show the limitations of private markets. In a study conducted by Charles Skorina, an Arizona-based consultant, over ten years, none of the investment portfolios run by eight Ivy League universities and 52 other endowments outperformed a basic U.S. stock market tracker fund. There is consensus among some that the best days are in the past for private equity managers, who have grown rich off performance fees. Under one estimate, investors have paid $230 billion in such fees over a ten-year period for returns no better than they would have gotten with a tracker fund that cost a fraction of the price.
That’s exactly what members of USS are afraid of. They say that the pension fund, with its 50-person private markets team, should not be plugging money into private equity and that it does not have the expertise to manage direct stakes and leveraged positions in companies and assets across multiple sectors, especially at such an uncertain time. “USS is a pseudo–public sector scheme — they don’t pay market rates for the investment team,” notes Bristol University’s Davies. “If they’re trying to do anything fancy, they’re going to walk into the room and get screwed.”
Pilcher disagrees. “Investments that we’ve made on the private side are probably too complex, too difficult for people in the public markets to understand,” he says. “For me it’s about a different approach — looking to take advantage of our strong position as a long-term investor and investing differently in light of that.”
Half a million academics are counting on him being right.