With the UK on the verge of quitting the EU, Mona Dohle asks if pension schemes are ready for independence.
Halloween could be a day that divides Britain. For some 31 October will see Britain free itself from the shackles of the European Union (EU), while others fear the country might enter a period of economic hardship and geopolitical isolation. Irrespective of one’s political orientation, Britain’s exit from the EU will have been high on the agenda at trustee and investment management meetings since the country voted to leave more than three years ago.
Pension schemes are bracing themselves for a triple challenge from Brexit. The UK’s exit from the bloc is predicted to hit funding levels and the employer covenant while greater volatility and a weaker pound could negatively impact investment portfolios.
The question is, have pension schemes, which are traditionally reluctant to make temporary policy changes, revised their strategies ahead of the big day? And what are the main operational challenges that they might face?
Most schemes have not released a statement about their investment strategy on Brexit given the unpredictability of the outcome. Moreover, schemes do not want to give the impression that their investment decisions could be driven by short-term tactical moves, rather than long-term strategic asset allocation.
David Cox, Brunel Pension Partnership’s head of listed markets, says that his team are aware of the turbulence that could hit financial markets after Halloween.
The £30bn pool, which brings together the investments of 10 local government pension schemes, has a decentralised structure whereby each of its local pension funds continue to hold fiduciary responsibility. As a result, the level of adjustment to Brexit varies between the individual authorities.
“We are conscious of rising volatility in the market increasing transition risk,” Cox says. “We have not changed our well thought out investment strategy, although we remain agile enough to respond as necessary.”
Anxiety around Brexit ties in with fears about the health of the global economy, which is why many defined benefit (DB) schemes have been reducing risk in their portfolios well ahead of October’s leave date. But for Brunel, reducing exposure to UK equities is not on the agenda. Cox points out that many of the biggest firms listed in London are so globalised that they might be more affected by currency movements in other markets, rather than the UK market per se.
It is a different story for Mark Hedges, chief investment officer of the £3.2bn Nationwide Pension Fund. He is reducing the scheme’s equity exposure. Despite the scheme having a relatively higher proportion of active members, he is focusing on matching liabilities.
“We continue to diversify our exposure which is already very global, certainly in our return seeking assets,” Hedges says. “Our matching assets are obviously linked to UK liabilities, so primarily they are linked to gilts, index-linked bonds and some UK index-linked property, which also acts as a partial hedge to the liabilities, both of which have gained foothold irrespective of Brexit because they are matched to UK interest rates. “The sharp fall in rates that we have seen since the end of last year had an impact on our liabilities, but that impact has been lessened because we have increased the hedging on inflation and particularly on interest rate risk. It could have been a lot worse because it was the uncertainty around Brexit that stimulated the fall in rates.
“It is also compounded by the global slowdown, but the bigger driver in the UK is probably Brexit,” Hedges adds. “Certainly, our deficit would have been in a much worse position had we not significantly increased the hedging over the past two years.”
This is a trend that has caught on. More than 75% of private sector DB assets are now hedged against interest rate and inflation risks, according to a 2018 survey by Hymans Robertson. Over the past two years, private sector DB schemes have added some £100bn of notional interest rate exposure, the consultancy says.
One of the clearest indicators that institutional investors could face potential challenges from Brexit has been the sharp fall in the sterling with the pound sinking to a 28 month low this summer.
Yet a weaker pound could also be an opportunity. “The challenge that we have seen recently is the fall in sterling, which has had an effect on our foreign assets to the extent that they are not hedged for currency risk,” Hedges says.
He adds that the team are considering locking in some of the gains. “We run 20% of our portfolio in private markets, so illiquid assets like private equity, infrastructure, private credit, real estate, in Europe and Asia,” Hedges adds. “That is a global portfolio but a large proportion of it is denominated in US dollars, which we have not hedged because it is difficult. For example, with a private equity fund, you do not know when you are going to drawdown the money, you do not know how much money you are going to get back and you do not know when you are going to get it back.
“One of the things we are contemplating, because we have seen the sharp fall in sterling, is if we can lock in some of the value from the currency gain of that translation risk ”.
“We have about $600m to $700m (£499m – £582m) of US dollars and a 10% fall in sterling effectively increases that by about $70m (£58m), so it starts to become appreciable to hedge that for a period of time,” he says.
“We are contemplating overlaying our strategy with currency forwards to try and lock in some of the gains, but if we do that and sterling falls further then we are also losing out on the value of further falls.”
But making bets on how Brexit could affect the value of the pound might be a strategy that is harder to sell to risk-averse trustees, Hedges admits. “Whenever you take these tactical risks, you are forming a view that sterling is under-priced, it probably is under-priced but it’s a question of how much further it could go and for how long, we don’t know. That is the problem with tactical decisions.
“It is something we are thinking about, but I won’t know until we had a formal decision from our investment committee,” he adds. Nevertheless, he believes that this strategy might be on the agenda for quite a few schemes. “Adding an overlay strategy to the macro level is certainly a strategy that pension funds are thinking about right now,” Hedges says.
“Unless there is a significant sea change in the UK government’s willingness to negotiate, I don’t see there being a big turnaround in sterling. It seems highly likely that there will be a painful Brexit rather than a withdrawal agreement at the moment,” he predicts.
Yet, since Hedges spoke to portfolio institutional the chances of the UK leaving the EU with an agreement increased after parliament voted to block a no deal Brexit.
SCHEME FUNDING – THE £140BN QUESTION
Brexit could, and to some degree already has, affected pension scheme funding levels. The impact could be felt on the liabilities side but also on the employer covenant.
Paradoxically, despite the macroeconomic adversities that the UK has been facing since the vote to leave the EU, pension schemes have improved their funding levels. Fuelled by quantitative easing and buoyant equity markets, DB schemes in particular have seen a solid rise in assets over the past 10 years, which has offset the increase in liabilities. As of 2018, UK DB schemes had a £117.1bn surplus, a relatively comfortable position compared to the £41.1bn surplus they had four years ago, according to the Pension Protection Fund. Moreover, because most equity assets are non-domestic, schemes have benefited from the falling pound, while the higher gilt yields have so far reduced the level of liabilities.
Consequently, The Pensions Regulator (TPR) appears to be approaching the Brexit risk with a typically British “Keep calm and carry on” attitude. “We have used our new supervision approach to explore with some of the most significant schemes what they are doing to prepare for Brexit. They have reported that they are generally confident they will weather any short-term volatility, if it comes, because of their longterm investment strategies and risk management approaches. Schemes also report that, where appropriate, they have been talking to employers about covenant risk, a TPR spokesperson said. But a lot will depend on what kind of Brexit the country is facing. Leaving without a deal might provide another, albeit temporary, boost to pension assets, yet the beneficial effects would be annulled by a sharp spike in liabilities, predicts Toby Nangle, head of global asset allocation at Columbia Threadneedle, an asset manager. He also forecasts that further rate cuts and the devaluation of sterling could provide a £90bn boost to DB pension assets. At the same time, the present value of liabilities could rise by more than £140bn, resulting in an overall deficit of £55bn. This could be averted if a last minute withdrawal agreement is decided, predicts Nangle, who argues that a softer Brexit could leave schemes with a surplus of £85bn. “From a pensions perspective, the short-term impact of the next steps for Brexit look to be a question worth around £140bn,” he adds.
PROJECT COPY AND PASTE
Deal or no deal, leaving the EU means that European regulations and directives will no longer be implemented into UK law, offering parliament more autonomy to decide on legislation. Does this mean that the current pensions legislation will be completely revised?
Paul Phillips and Ferdy Lovett, partners at law firm Sackers, argue that Brexit is unlikely to result in any dramatic legislative changes.
One key concern has always been that Brexit could affect the Ucits passporting rules, which allow EU domiciled asset managers to market their products and services in the UK and vice versa. So how will pension schemes deal with reduced access to investment management services? Columbia Threadneedle and M&G have moved billions of pounds worth of assets to Luxembourg and Ireland, yet the actual fund management still largely takes place in the UK.
Philips and Lovett are confident that by now most asset managers have taken precautions.
“Our clients are checking with many EU27 providers, most seem to have applied for temporary permissions or have already made full-blown applications to distribute their funds, so we haven’t encountered any problems to fund distribution yet,” Phillips says.
The laws governing the operational management of UK pensions will also not change in the short term, most of whom were UK specific anyway since pensions law is largely decided on a national level, Lovett says.
“They initially wanted to call the withdrawal treaty ‘The Great Repeal Bill’ but then changed its name to the ‘Withdrawal Act’,” he adds. With more than 52,000 pieces of legislation needing to be changed as a result of leaving the EU, any laws currently being in place have been moved onto UK statues to avoid black holes in legislation, Lovett says. “So it is really more of a project copy and paste,” he adds.
Nevertheless, Parliament does now have the option to revise pension’s rules in the longer term, but this is likely to be a lengthy process he predicts. “It really depends on what kind of Brexit we will see but we think any changes for pension schemes will be market driven rather than legislation driven. From an operational perspective, the main challenge for schemes would be that at any given time there will be a number of schemes looking to conduct major transactions or move member money into other locations, especially schemes looking to prepare for a buy-out or having recently completed a buy-out deal,” Lovett says. While the de-risking market has so far had a strong start of the year, market volatility as a result of Brexit could be a challenge in implementing the shift in responsibility to the insurers.
“Schemes will have to be careful to prevent any major movements in October, you don’t want to be buying and selling too much at a volatile time,” the team at Sackers warns.