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Brexit Investment Implications for UK Pension Schemes

Posted by Donny Hay on Jul 17, 2017 3:03:48 PM

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The results of PTL’s recent Defined Benefit (DB) Risk survey (click here to see the results) showed that Brexit was one of trustees’ top three DB risks. So, one year on, what has happened, what are the risks and how can trustees mitigate them?

Following the UK’s EU referendum on 23 June 2016 sterling fell 20%. On the other hand, after an initial sharp fall, the UK stock market has since rallied giving a 17% net gain over the last year and 10-year gilt yields – having fallen last summer from 1.40% to a low of 0.52% –have recovered to 1.30%. Then came the shock election results on the 8th June and the government’s loss of an outright majority. Now rising inflation and ongoing concerns about economic growth prospects have left many trustee boards scratching their heads and asking where to next?

So what are the risks?

The weaker pound is not in itself a problem for DB pension schemes, given that pensions are paid in sterling. But its impact on UK inflation, bond yields and the value of pension scheme assets does matter. Higher inflation leads to higher pensions, lower bond yields increase the current value placed on these future pension payments, and political uncertainty risks a flight of capital from the UK, potentially reducing the value of UK pension scheme assets. On the flip side, there would likely be an offsetting benefit from overseas investments rising in value.

So how can trustees mitigate these risks?

There are four key areas on which to focus:

Diversification: Often called the only ‘free lunch’ when investing. It pays to spread investments, both geographically and across different asset classes. Most DB pension funds have reduced their allocation to UK equities and bonds in favour of similar global assets, but this is worth revisiting with your investment adviser to ensure your strategy remains optimal.

Hedging: Unlike investing in equities or credit, where you can earn a ‘risk premium’, there is no similar benefit to be gained by leaving a pension scheme’s interest rate and inflation risks unhedged, only an opportunity cost or gain. This is the single most misunderstood investment concept in DB pensions, and it has cost sponsors dearly. Given that most pension funds have now diversified their assets from a high exposure to equities, unhedged liabilities are by far the biggest risk facing most DB pension schemes today. Neither trustees nor sponsors can put their heads in the sand – both need a strategy to manage this risk. Foreign currency exposure is also a risk that can be hedged, but there are also diversification benefits accruing from overseas assets. As a rule of thumb, hedging all of your developed-markets fixed interest exposure and half of your equity and property exposure has been shown to work well. At the same time, research suggests you should leave your emerging markets exposure all or largely unhedged.

Play the long game: Successful investment is about taking advantage of uncertainty, i.e. investing when things look bad (and cheap!) and staying fully invested if you are a long-term investor such as a pension fund. Resist the temptation to call the market – it is time in the market that counts, not timing the market!

Control costs: It goes without saying that the more return you keep, the greater the value of assets to meet pension payments. Costs eat into that return, whether through investment management or advisory fees, pension scheme running costs or transaction costs. The starting point to controlling costs is to understand them, then to assess them for value for money. That’s not to say that cheap is good; quality matters, especially in the investment world, but trustees need to get under the bonnet. This isn’t easy but you must find a way to assess value. There is a lot of opportunity for value leakage out of eye sight.

In conclusion, Brexit has highlighted a number of investment risks that trustees need to control, but in reality those risks have always been there. So trustees should view this as an opportunity to review and refine their investment strategy.

 

Topics: Defined Benefit, defined benefit risks

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