As the dust begins to settle on the UK’s vote to leave the EU, Natasha Browne looks at five ways Brexit will affect pension schemes
Stock markets and sterling nosedived in the wake of the British electorate’s decision to leave the EU on June 23rd. Sterling alone plummeted from $1.50 against the US dollar to $1.33 within hours after the vote. Although stock markets have mostly rebounded, sterling remains low.
However, it is not all doom and gloom. Insurers have cut their pricing on de-risking strategies amid lower asset prices. And for firms that previously failed to hedge their currency risk now is the optimum time to take action.
Here are five issues that schemes need to think about:
There are employers who are particularly vulnerable to the immediate effects of Brexit, as well as those who will make gains off the back of the vote. The drop in sterling is bad news for importers and the travel industry, but it is a bolster to exporters. And while cheap borrowing costs are an advantage for leveraged businesses, they exacerbate the size of notional debt – the pension scheme.
It is crucial for trustees to have collaborative discussions with sponsors to offset any headwinds!
It is therefore crucial for trustees to have collaborative, open discussions with their sponsors in order to offset any headwinds. Lincoln International managing director Alex Hutton-Mills says: “The more you think that you’ve got a rock-solid covenant and you’ve got a tiny scheme, the more comfortable you are with taking credit risk because the covenant can absorb that risk. So the fundamental question is how comfortable the trustees are with the underwriter in a post-Brexit scenario.”
One way to keep track of the strength of the scheme is by monitoring its funding on a Pension Protection Fund (PPF) basis. But according to Hutton-Mills, plenty of schemes are unaware of their s179 funding level. Trustees are concerned with the accounting deficit, technical provisions and solvency. But they often neglect to ask how the PPF liability is changing over time. By simply including the PPF drift in their scheme returns, trustees will be able to monitor their schemes more closely.
Law and regulation
There is no immediate effect on regulation since the UK is still a member of the EU and Article 50 is yet to be invoked. However, it is unclear whether or not regulators will adopt IORP II given that the timeframe for implementation runs parallel to negotiations on the exit package. Ultimately, the extent to which UK schemes must comply with EU regulation hinges on the details of its post-Brexit relationship with the bloc.
It is unclear whether or not regulators will adopt IORP II”
Sackers senior associate Georgina Beechinor says: “For defined benefit schemes, the key thing is for trustees and employers to ensure that their integrated risk management (IRM) plans are up-to-date. IRM is an ongoing process under which risk assessments should be carried out at regular intervals.
“Trustees should consider with their advisers the extent to which changing market conditions affect their longer term view of expected risk and returns, and how this interacts with their funding plans and risk appetite, rather than concentrating on short-term market movements.”
Trustees hoping to see the back of ‘full-funding’ requirements for cross-border schemes may be disappointed since members of the European Economic Area are also subject to the rule. Under IORP II, however, the use of recovery plans by underfunded schemes will be permitted. How this will work in practice, however, will depend on the UK’s implementation of the directive post-Brexit.
The Bank of England (BoE) has halved the base rate of interest to 0.25% and announced a stimulus package including £60bn of gilt purchases in response to economic concerns following he vote. Quantitative easing (QE) has already driven down long-term rates, which are at historic lows. This is a serious concern for schemes already operating in a low rate environment. Their liabilities and deficits are being driven upwards as a consequence of monetary policy.
Deficits are being driven upwards as a consequence of monetary policy”
In spite of this boost to the money supply, the fall in sterling is expected to create inflation through higher import costs, including on fuel. JLT Benefit Solutions director Charles Cowling said: “This is a double whammy pushing up liabilities. And although we’ve seen the same impact push up the value of market prices for bonds and equities, that’s not sufficient for most pension schemes to keep pace with what’s happening to their liabilities.
“As a result, deficits are going out, for some at least. And the ones who are most in danger are those who haven’t done a lot of matching of assets to liabilities and have big schemes relative to the size of the business.” Cowling recommends doing as much liability-driven investing (LDI) as possible and removing as many liabilities as possible.
Sterling has fallen by about 10% against other major global currencies since the referendum. And a typical scheme would hold between 30%-50% in foreign currencies, meaning a 10% fall in sterling adds 3%-5% to the value of their assets. The flipside is that a weaker sterling restricts schemes’ ability to increase their foreign exposure.
If schemes have not hedged, this is a God-given opportunity to do so”
Charles Goodman, UK chief executive officer Edmond de Rothschild Asset Management explains that unhedged schemes have been lucky in the past, with sterling losses witnessed in 2008 and again in 2016 boosting funding. But he adds: “The rest of the time sterling has mostly gone up. People have generally lost money if they haven’t hedged, but it’s been quite slow so it’s not been so spectacular.
“If schemes have not hedged, this is a God-given opportunity to do so because you’ve got this weakening of sterling. And from a long-term perspective it makes sense to hedge because you can take out some volatility and you should not be taking out any expected return.”
The two main instruments for hedging are forward contracts and currency options. A scheme based in sterling with part of its portfolio in dollars can look to hedge periodically. This involves reducing hedging when the dollar rises. Goodman says: “The rational for that would be to reduce the potential negative cash flows that could come from hedging in periods of currency strength.”
Insurance companies all had contingency plans in place before the referendum. Many had also restricted their portfolios to cope with the uncertainty created by the vote. There are now pricing benefits because the value of assets that insurers rely on to match liabilities have been reduced. And according to LCP partner Charlie Finch, these savings are being passed on to pension schemes.
Buy-ins continue to be very attractive”
He says: “For recent quotations we’ve had seven or eight insurers quoting and the pricing we’ve been seeing has been better value than holding gilts in terms of the lower price compared to what you have to reserve for if you are just investing in gilts to back the liabilities. Buy-ins continue to be very attractive and I think we’ll see more of them.”
Still, the majority of UK pension schemes only hedge about 60% of their liabilities. This means 40% of the increase in liabilities as a result of reduced interest rates will not have been matched by asset performance. Still, if schemes have umbrella contracts in place they will be well-positioned to de-risk when pricing is favourable. But contracts take between one and eight weeks to formalise and, as Finch points out, a delay of a week could mean losses of £5m without the ability to de-risk.
The prospect of a UK departure from the EU has shocked many. There is no doubt the climate of lower rates and higher inflation is a serious challenge for schemes. And the political wrangling that led to the referendum is a reminder of the exogenous risks to pensions. Trustees now face an even tougher task in managing their liabilities and deficits. Still, through flexibility and the right advice, schemes can navigate their way out of potential chaos.