Schemes are facing an uncertain two years, with plenty of risks to look out for. Jack Jones reports
After eight months, the Brexit phoney war is over. On 29 March Prime Minister Theresa May triggered Article 50, starting a two-year countdown to the date the UK will exit the European Union. She described the day as “an historic moment from which there can be no turning back”.
So now that we have a little more certainty about the timeframe for negotiating our break with the continent, are we any clearer about how schemes will be affected by this development?
The answer is a qualified no.
There are risks, and there are possible outcomes, some of which could be uncomfortable
JLT Benefits Solutions director Charles Cowling says: “There are no clear answers and no particularly obvious ways this could go, but there are risks, and there are possible outcomes, some of which could be uncomfortable, so trustees should keep an eye on things.”
There are plenty of developments that could have a significant impact on investment markets, funding levels and covenant strength. There is also the very important question of whether withdrawing from the EU will alter the regulatory landscape for trustees.
The impact on funding levels is one of the big unknowns. Pundits have already been surprised by the response of the markets to the UK voters’ decision last June. The meltdown predicted by many economists ahead of and in the immediate aftermath of the referendum has failed to materialise and markets have generally performed strongly.
So it would be foolish to try to call how markets will respond to the inevitable twists and turns of the next two years. But it is a fairly safe bet that inflation will cause some concern for trustees. Sterling fell steeply after the vote and has remained weak by historic standards, contributing to a rise in inflation. Earlier in 2017 the 12-month Consumer Prices Index rate exceeded the Bank of England’s 2% target for the first time in three years.
As most defined benefit liabilities are linked to inflation this will cause schemes some pain in the form of higher outflows, as benefits are increased in line with inflation. If actuaries hike their inflation assumptions on the expectation that a weaker Sterling will be a feature of post-Brexit Britain, liabilities will also rise.
Cowling says: “Clearly trustees have to keep a close eye on funding in any event, and there are possibly bigger issues in terms of Brexit’s impact, but a hard Brexit could still cause some serious problems if it results in a major Sterling devaluation, big inflation and very unsteady markets.”
Uncertainty over funding levels is a particular concern when it goes hand in hand with concerns over covenant. In the immediate aftermath of the vote, the Pensions Regulator put out a statement advising trustees to get a handle on the employer-specific impact of Brexit.
TPR STATEMENT: KEY MESSAGE
”Our key message to trustees and sponsors of occupational schemes is to remain vigilant and review their circumstances, but continue to take a considered approach to action with a focus on the longer term.
”It is too early to understand or assess the full consequences of the outcome of the EU referendum in detail. However, we expect trustees to have an open and collaborative discussion with their sponsor about the possible effects to their business. The referendum vote has also resulted in market volatility, and many commentators have predicted that there is likely to be more in the coming weeks and months. Pensions are long-term investments and trustees should, as part of their ongoing risk management, review their position, but consider their circumstances carefully before taking action at the appropriate time. Trustees and sponsors should speak to their advisers if they are concerned or need help in understanding the risks.”
For some schemes, Brexit could hand their sponsors a boost. A weak pound is a shot in the arm for exporters. These firms will be eyeing trade talks nervously, but in the meantime will have the chance to make some hay as the pricing of their products looks more attractive overseas.
But if you’re reliant on consumer confidence – the construction or leisure and tourism sectors for example – then your sponsor is likely to take a hit when this drops.
There are very likely to be some bad news stories around trade negotiations that cause wobbles in consumer confidence
“If you’re a business that is inherently cyclical or relies on consumer confidence remaining strong, then there has to be some nervousness there, because over the next two years there are very likely to be some bad news stories around trade negotiations that cause wobbles in consumer confidence,” says Lincoln Pensions managing director Matthew Harrison. “I don’t foresee it being a steady easy ride to a nice smooth Brexit.”
The next step after identifying how exposed a sponsor is to Brexit risk is to put in place an appropriate covenant monitoring plan. The regulator wants trustees to be re-examining covenant strength annually, at least. Trustees who are nervous about the impact of Brexit should be monitoring more frequently than that.
Schemes will also have to keep an eye on metrics that might herald a downturn in their sponsor’s sector – like the Consumer Confidence Index, Purchasing Managers Index or foreign exchange (FX) projections.
The macro-economic factors won’t just have an impact on the sponsor, they will affect the investment position of the scheme
Harrison says it is important to consider the impact of these factors on both the scheme’s sponsor and its funding level. “You have to monitor those metrics relative to the scheme,” he says. “That’s really important with Brexit because a lot of the macro-economic factors – like FX, or inflation, or interest rates – that will be affected by Brexit, won’t just have an impact on the sponsor, they will affect the investment position of the scheme.”
In the best examples of monitoring, trustees have set up protocols so that if anything material happens, the employer will inform the trustees on a real-time basis.
This could be a formal agreement with clear obligations on the sponsor, or it could involve triggers that will prompt trustees to request information from the firm. The more concerned trustees are, the more formalised those protocols should be.
But Harrison says the only examples he has seen of these kind of arrangements have been the result of triennial funding discussions. Few trustee boards seem to have set up additional monitoring protocols simply as a response to Brexit.
The regulator was saying ‘you should get on the front foot and understand the risk profile’
“The uncertainty around Brexit has been treated by many trustees as a case of ‘wait and see’, but actually the regulator was saying ‘you should get on the front foot and understand the risk profile’,” he says.
“It’s not clear to me that monitoring templates have changed in reaction to Brexit and the uncertainty associated with it.”
The degree to which pensions regulation is likely to change is also unclear, but the most likely outcome is little immediate movement. The government’s ‘Great Repeal Bill’ will import European law wholesale, and ministers will then decide which bits to amend or discard.
Arc Pensions Law partner Rosalind Connor says: “My gut feeling is that the government will change very little.”
Even if the government argued that it could repeal the current funding regime, it is unlikely to have the appetite to do so. The same goes for anti-discrimination measures, argues Connor. No government would find it easy to roll back laws that say schemes can’t pay members lower pensions simply because they are gay or disabled.
But one area where leaving the EU could lead to an easing in regulation is the treatment of guaranteed minimum pensions (GMPs). The government has suggested it will push ahead with equalisation requirements, but there is a chance now it could opt for a simplified process, safe in the knowledge that its work will not come under the scrutiny of the European courts. For now, many schemes will want to wait and see.
There’s certainly no incentive on pension schemes to do something until the legislators make it absolutely clear
“There’s certainly no incentive on pension schemes to do something until the legislators make it absolutely clear that it’s got to be done,” says Cowling.
“The one slight proviso to that is that if you can get rid of GMPs by conversion, it makes it a darn sight easier and cheaper to do buyouts.”
One red flag that Cowling raises, is that if negotiations turn sour the regulator – and trustees – might suddenly find it more difficult to enforce pension debts against European parent companies.
Although the watchdog has had success acting against Russian and American firms in the past, pursuing parent companies through foreign court systems is complicated.
“And if the UK government decides that no deal is better than a bad deal and chooses not to honour its pension obligations to European civil servants, you could see the European courts getting quite hot under the collar about UK companies then coming to European companies demanding payment of pensions debt,” says Cowling.
So schemes with worrying deficits, sponsors exposed to serious Brexit risk, and a European sponsor could be in for a fraught two years.
BREXIT: A TIMELINE
April 2017: EU-27 agree guidelines
At the time of going to press, it looks likely the 27 other European Union countries will adopt tough guidelines on how the negotiations will run at a summit on 29 August. The draft produced by European Council president Donald Tusk means Britain would have to accept the EU’s laws, court and budget fees to secure a gradual transition from the single market.
June 2017: Negotiations start
Negotiations cannot take place until the EU-27 formally nominates the European Commission as its lead negotiator and gives it a detailed mandate. Developing these directives will take around a month, and the final draft must then be approved by member countries, meaning formal face-to-face talks with the UK will probably start in early June.
May 2017: Great Repeal Bill introduced
The Great Repeal Bill is designed to provide legal continuity for the UK after Brexit. The bill will repeal the European Communities Act of 1972 and incorporate EU law into domestic law so that the government can begin amending or repealing laws it does not want to keep. The measures will not come into force until the country leaves the union.
December 2017: Agreeing the Brexit bill
EU negotiators want to put off talks on a future trade deal until Britain has agreed in principle how much it will pay to meet its already agreed liabilities and what the rights of EU migrants will be. These discussions could last until December, but the UK government wants to negotiate all elements of Brexit at once. The EU 27 are in agreement however, so it is unlikely trade talks will kick off before the end of the year.
March 2018: UK deadline for agreeing transition
By next March the clock will be ticking and companies will start taking action to protect their business. The UK is keen to have transitional arrangements agreed by this point, but its negotiating partners are in less of a hurry.
October 2018: EU deadline to agree deal
The European Commission’s chief negotiator, Michel Barnier, wants talks concluded by October 2018 to give both sides six months to ratify the deal before the Article 50 deadline.
March 2019: Ratification
EU member states, the European Council and the European Parliament must have ratified any agreement before the two-year deadline, and in the UK, parliament will have to endorse the deal.
April 2019: So long!
Brexit will be completed, and the hard work on those trade talks with the rest of the world will begin.