On Thursday 23 June, a majority of voters agreed that the UK should leave the European Union (EU). This result was one of the few solid facts to emerge from the referendum. The UK now faces an extended period of instability and uncertainty as politicians, investors and businesses enter a new geopolitical landscape.
What does the vote mean for pensions in the UK? What should trustees and employers be thinking about, discussing or even doing? In this Insight, we'll be looking at the impact of the referendum on:
- the legal framework for pensions;
- pension scheme investments;
- scheme funding; and
- employer or sponsor covenant strength.
The impact of the Brexit vote in four key points
No change to the current legal framework for pensions
There was no immediate change to the legal framework governing pensions following the vote. It is unlikely there will be a material change in the short to medium term. Any longer term impact will depend on how the UK exits the EU.
Scheme investments - increased risk and volatility
Pension schemes face increased volatility in the immediate and short-term. Certain investments will have a higher level of risk than before the vote.
Negative impact on scheme funding
Scheme funding has already been negatively impacted. There is likely to be further negative impact on scheme funding as the Bank of England and HM Treasury take steps to stabilise the UK's economy.
Potential impact on employer covenant strength
Trustees should already be monitoring employer covenant strength and should be prepared to act to safeguard the scheme's financial position if necessary. Certain types of employer and sectors are potentially more vulnerable to market volatility and the UK's exit from the EU and should therefore be monitored more closely.
Next steps and actions in four key points
Talk to professional advisers
Trustees and employers should engage with their professional advisers as an immediate 'next step' and use this to gauge whether more urgent action is required.
Dialogue between trustees and employers
Trustees may also want to engage with employers to better understand what steps they are taking in respect of Brexit. Trustees and employers should discuss whether it would be appropriate and sensible to issue a communication to members.
Integrated risk management
Trustees can use Integrated Risk Management (IRM) principles to help identify, discuss, prioritise and manage risks.
Review investment strategies and options
Trustees and their advisers should consider the suitability of investment strategies, investment options (for defined contribution members) and the terms of current investments (i.e. swaps and derivatives).
Pensions legal framework and Brexit
Did the vote change the legal framework for UK pensions?
The legal framework for pensions in the UK was exactly the same on Friday 24 June as it had been the day before. The vote seems to have changed everything in politics, but it changes nothing in law. The referendum itself was non-binding and did not, in and of itself, trigger the UK's exit from the EU.
That means that all of the primary and secondary legislation, case law (including European case law) and regulatory guidance remains in force and unchanged.
This was reiterated last week by the Financial Conduct Authority confirming that firms must continue to comply with EU regulations and that it would continue to implement future regulatory change.
Why is there so much uncertainty and how will this impact on pensions in the UK?
There are two main reasons why things are so uncertain:
- the first is that we do not know how, or even if, we will leave the European Union;
- the second is that we do not know when we will leave or even when we'll have a clearer view of the process.
If the UK government negotiates to leave the EU but retains a high level of access to the single market, the legal framework governing UK pensions may not see a material change. The UK would still be required to implement most, if not all, of the EU's legislation covering pensions and employment.
A more complete break with the EU may result in the UK developing its pensions legislation and regulation in a very different way to the remaining 27 member states of the EU.
In such circumstances, a more radical UK government could legislate to fundamentally change the established legal framework for pensions.
The extent to which current or new EU pensions legislation will have to be implemented is unclear. Of particular interest to the pensions industry are unresolved issues on:
- the General Data Protection Regulation, which will go into direct effect in EU member states on 25 May 2018;
- IORP II, which has recently been adopted as law by the European Council and the European Parliament. Member states now have two years to implement IORP II into their national legislation.
In addition, questions have been raised about whether schemes will need to equalise GMPs (guaranteed minimum pensions) and what VAT provisions will apply after the UK leaves the EU.
Until we have a clearer picture of the future relationship between the UK and the EU, it is impossible to provide legal certainty on these issues.
Pension schemes and risk
Trustees and their advisers will have to consider the impact of the vote and future exit negotiations on the scheme's ability to fund accrued liabilities. In particular, trustees will need to think about:
- scheme investments;
- scheme funding levels; and
- the strength of the employer / sponsor covenant.
Note: We are legal advisers, not actuaries, investment consultants or covenant specialists. From a governance and legal perspective, these are the steps and thought processes which trustees ought to be going through over the coming weeks and months.
Pension scheme investments and Brexit
Markets have reacted to the Brexit vote in very different ways. Trustees and their investment advisers may have to get used to uncertainty being one of the only things that we are certain of.
Trustees will have set their investment strategies and outlined their tolerance for risk before the vote. The result of the vote represents a material change in the investment and risk landscape. Trustees will need to consider whether:
- their scheme's investment strategy is still appropriate in light of developments. Have trustees discussed their with their investment advisers?; and
- their scheme's investment strategy is still meeting their objectives for risk tolerance. If not, do the trustees need to reconsider either their risk tolerance or their investment strategy?
More specific issues relating to investments include:
- Counterparty credit rating downgrades which could trigger termination rights;
- The value of collateral posted under derivatives and swaps reducing in value resulting in margin calls (from both sides); and
- Whether the range of defined contribution investment options is still appropriate and whether they are still labelled and described correctly.
Pension Scheme funding and Brexit
Since the vote, the UK's credit rating has suffered further reductions. Most notably, Standard & Poor became the last of the three major rating agencies to remove the UK's Triple-A rating.
This has, somewhat counterintuitively, reduced UK gilt yields and increased bond yields. Despite the reduction in the UK's credit rating, its sovereign debt is still seen as a safer haven than other investments. Last week, two British sovereign bonds traded in negative territory for the first time.
This has a direct impact on scheme funding levels. According to Hymans Robertson, aggregate deficits had risen to £935 billion last week.
Further impacts on scheme funding levels will depend on what action the Bank of England and Government take.
The markets are now braced for a further fall in interest rates and the potential for another round of quantative easing. There could also be further downgrades in the UK's rating.
There could also be an increase in transfer requests as members seek to take advantage of high transfer value levels.
Each of these will have a material impact on pension scheme funding with falling bond and gilt yields and unfavourable scheme-funding provisions.
Employer covenant strength and Brexit
The Brexit vote is an additional consideration for trustees and will be factored into employer-specific, sector and macro-economic forecasts. It does not, in and of itself, necessarily require perceptive action from trustees.
Some of the factors which trustees can consider in this respect include whether the employer / sponsor is:
- exposed to fluctuations in listed markets and commodities?
- exposed to volatility and a longer-term weakening in Sterling?
- based in or outside of the UK?
- moving employees, assets, tax residency, stock market listings or headquarters out of the UK?
- operating in a sector or markets that is commonly believed to be vulnerable or exposed to Brexit? Commentators in the financial press have identified these sectors as ones to be aware of:
- banking and insurance
- other financial and professional services;
- manufacturing, especially with large European exports;
- chemicals and pharmaceuticals; and
- construction (especially homebuilders).
Pensions and Brexit - next steps
So, when faced with turbulent markets and an uncertain future, what should trustees and employers do? What are the practical and sensible steps that those involved with UK pension schemes should consider?
Integrated risk management
Fortunately, there is already a mechanism in place by which trustees can engage with risk in the form of integrated risk management (IRM). The Pensions Regulator has made this a big focus over the past few months since it published guidance on it in December 2015. This is a real test for the methodology.
IRM asks trustees to focus on risks in relation to:
- funding; and
- employer covenant strength.
It is important to note that IRM is not a panacea or a solution in and of itself. It is a set of tools that enables trustees to identify risks and make better decisions in relation to those risks.
As part of IRM, this should be a standing item on trustee agendas. Brexit doesn’t need to be a separate heading - it can be considered as part of the overarching risks that I've just mentioned.
Because of the current level of uncertainty, we are not suggesting that all trustees need to commission an urgent covenant assessment, revise their statement of investment principles or attempt to negotiate on increased funding.
It would, however, be very sensible for trustees to engage with their professional advisers to ensure that:
those professional advisers are monitoring developments and are committed to providing the trustees with information as needed;
channels are opened to enable the trustees to take prompt action if this is required.
Employer and trustee engagement
The Pensions Regulator is keen that trustees and employees discuss issues early and often. This does not mean that the trustees need to take precipitative or provocative action such as questioning covenant strength.
It does, however, serve to remind employers that the pension scheme is a key consideration in relation to their planning for Brexit.
Trustees should ensure that they have sufficient information from the employers to enable them and their professional advisers to be able to monitor covenant risk.
Suitability of investment strategies and options
As part of their engagement with investment advisers, trustees should consider whether their investment strategies are still appropriate. Trustees will have adopted a certain tolerance for risk when deciding their investment strategy. Does the investment strategy still reflect that risk tolerance in light of current and extended market volatility?
In addition, trustees may need to consider the suitability of the range of investment options that are available for defined contribution members (including those making additional voluntary contributions). Providers should be able to confirm whether the fund selection remains appropriate for various risk thresholds or if any changes need to be made.
Due diligence on existing investments and contracts
Trustees with derivatives or swaps in place may want to ask their legal advisers to confirm whether there is any counterparty risk and ratings downgrade triggers which could become relevant in the short and medium term?
They should also ask their investment managers whether any collateral posted under such contracts has reduced in value because of falls in currency or equity prices such that a call may be made from counterparties.
Does the scheme have sufficient liquidity in its current investment strategy to deal with any such issues?
In the longer term, trustees may need to consider issues around financial services passporting for any non-UK banks and financial service providers.
Finally, we've had reports of a spike in queries from members who are concerned about the safety of their pension savings. Trustees may want to consider issuing a statement to members in order to reassure them that they are taking appropriate steps, are monitoring the situation and reminding them that the fundamental system of safeguards and protections remain in place.
Trustees may want to discuss this with the employer to ensure that messages to employees and members are consistent.