The UK electorate’s historic decision to leave the European Union (EU) has come as a huge surprise. As predicted by experts, the majority Brexit vote led to falls in the equity markets and gilt yields as well as sterling which dropped to a 30-year low on 24 June.
The moves immediately affected defined benefit (DB) schemes with the total funding deficit increasing overnight by £80bn to £900bn as yields fell by as much as 30 basis points (bps).
With lack of clarity over when exactly the UK will push the button to exit the EU and Westminster in disarray following the prime minister’s resignation, the months ahead will be very bumpy.
Rough ride ahead
PTL managing director Richard Butcher says: “There’s no doubt the emotion of Friday 24 June caused the markets to be far more volatile. That will settle down in some form over the coming weeks and months – but it could take a long time as what the markets dislike most is uncertainty and we’ve just voted for at least two, three years of uncertainty.”
KPMG pensions partner Stewart Hastie warns DB schemes will be in for a “rough ride” with the prospect of higher inflation, and the expected drop in pension asset values over the next couple of years. They are likely to face lower for longer gilt yields which have already increased many schemes’ deficits in recent years.
“Long end government bond yields will likely stay stubbornly low keeping pension liability values high and meaning pension deficits are likely to increase and be more volatile,” he says.
The Pension Protection Fund’s (PPF) index at the end of May showed four in every five schemes were underfunded with an aggregate deficit of £320bn close to all-time highs.
“With some 2,000 schemes due to have a funding review in the next 12 months UK businesses will be under pressure to divert cash to shore up historic pension liabilities.”
While the market volatility is concerning, schemes should not assume there is an outright negative outcome for UK equities on a relative basis. Companies that export heavily will benefit from sterling weakness especially those that do not export into Europe, according to State Street Global Markets global head of macro strategy Michael Metcalfe.
“Equity markets have been volatile but the lower currency is acting something of a shock absorber, and gilt yields also to some extent. As bad as UK equities have been they have not underperformed, particularly Europe.
“Until we get a bit more clarity from the new prime minister and once the negotiations start as to what the UK’s economic relationship with Europe will look like, investors should not immediately leave UK equities because we’ve seen in the past that weaker currencies have actually helped global equity markets.”
The Bank of England has made encouraging signals it will support the economy, which has led the market to believe there is a possibility of reduced interest rates. However, it could also hike them to protect sterling and head off inflationary pressures.
Metcalfe cautions against assuming gilts will automatically be safe haven assets as there will be inflation risk. “That sterling weakness which protects your equity holdings is likely to come with inflation risk, and so particularly at the longer end of curve for rates that’s potentially a problem.”
On the plus side schemes with significant unhedged overseas investments could actually see their asset values increase at least in sterling terms.
Around 50% of DB schemes are invested in equities on average of which half is non-UK, so there is around 25% invested in non-sterling equities. So a 10% fall in sterling would arguably give a positive 2.5% return for non-UK assets, assuming they haven’t hedged any of them, according to Hymans Robertson chief investment officer Andy Green.
Don’t panic
Both DB and defined contribution (DC) schemes will no doubt want to review their investment strategies. Pension consultants are urging trustees against making knee-jerk reactions but rather to calmly assess their investment portfolios.
Butcher says: “The law of economics hasn’t changed as we’ve still got a long-term investment horizon, perhaps 70-80 years in DB, and 40-60 years in DC. So in a sense, we have to ride this out and look for longer term trends rather than react to short-term events.”
DC schemes will need to monitor how members react to the uncertainty over Brexit.
“I’d be quite nervous if we saw members moving to say cash because they’ll be too late as they’d just be locking in losses,” says Butcher. “So we want to monitor that and ensure our members are making informed decisions.”
On DB schemes, Spence & Partners director Hugh Nolan said in a note: “Trustees and sponsors need to understand the risks their schemes are facing in relation to currency, inflation, interest rates, equity markets and so on to check that they remain comfortable with their strategy. This assessment should be measured and focus primarily on the impact of the longer-term outlook for the real economy rather than short-term market movements.
“We expect to see job losses and reduced corporate profits in the short to medium term but the longer term position is more uncertain. There will also be opportunities to take specific actions such as reviewing the degree of inflation hedging in place or agreeing triggers to switch investments if and when the volatile markets hit a favourable level.”
Some schemes may have to change the level of investment risk if the sponsor covenant weakens in light of Brexit-related events.
Butcher says: “You need to be able to react to the change in the covenant, by gearing up or more likely gearing down risk exposure. If there is more risk in the employer, you’ll want less risk in investments.”
Pension schemes must prepare themselves for the challenging years ahead. Taking a considered and careful approach and looking beyond short-term market movements is advised. Hopefully, in the coming months the future of Britain’s economy, politics and its relationship with the EU will become clearer.
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