By David Hickey
The referendum on the UK’s membership in the EU has now been set for 23 June. The outcome is on a knife edge, according to some polls, which is unsettling for households, businesses and trustees of defined benefit pension schemes who may be wondering about the potential impact of a Brexit on their portfolios. So what might a Brexit mean for pension schemes and what can they do about it?
Why a Brexit Could Happen
Scepticism toward the EU has increased recently as a result of the continent’s economic challenges, with concerns around Greece’s economic stability just one example.
Rising feelings of nationalism cannot be completely ignored and are being fuelled further by an immigration crisis as displaced refugees flee escalating conflicts in the Middle East. Following an unsuccessful Scottish independence referendum in 2014, some Scottish nationalists may use an ‘out’ vote as a way to revive calls for Scottish independence with a view toward future EU membership.
Why a Brexit May Not Happen
The political and economic establishments in both the U.K. and Europe are largely in favour of remaining an EU member. The economic impacts of exiting are negatively skewed with the possibility for economic loss appearing much greater than potential gains. The U.K. and EU are significant trading partners; over 51% of U.K. exports landed in the EU in 2014 and a Brexit would likely impede this. Corporate rhetoric in the financial sector has already stirred concerns jobs could be relocated away from London; HSBC recently told Sky News that 20% of employees at its London headquarters could be relocated to Paris following a Brexit. In an open letter to The Times bosses of 36 FTSE 100 businesses backed staying in the EU, although it has been pointed out by the ‘leave’ campaign that this means two-thirds of FTSE 100 firms did not sign.
As a popular figurehead, Boris Johnson’s decision to back a Brexit was a big boost for the anti-EU campaign.
Our View
At present, we favour the odds of the U.K. remaining in the EU. However, if a Brexit does occur, we don’t expect it to be as disruptive as the more pessimistic forecasts predict. A probable long transition period should soften the immediate blow of a Brexit; but it would nevertheless undermine business, consumer and investor confidence and consequently risky assets. Sterling has already lost value against all major currencies and could weaken further. The uncertainty of not only the vote, but also the potential impact of a Brexit, could produce mixed results across equities and fixed income. If risk aversion were to increase sharply, we would expect long-duration gilts to outperform, while equities could slide.
What is the potential impact on defined benefit pension schemes?
For pension schemes, a Brexit could impact funding levels negatively if U.K. equities and other risky assets fall in value. In terms of bond yields (and thus pension liabilities), the effect could be twofold. A flight to quality within U.K. assets might lower rates, thus potentially hurting funding levels. However, if UK government debt is viewed less favourably by overseas investors and demand consequently diminishes, yields could rise which may actually improve funding levels in the short term. Weakening sterling would also favour pension schemes with overseas investments, again a plus for funding levels. Perhaps surprisingly then, a Brexit may be positive for schemes that are exposed to rate upside and hold a sufficient amount of global equities, but this is far from certain. The only thing that we can be sure of in the aftermath of a Brexit is volatility, which supports the case for a well-diversified global strategy.
While an ‘in’ victory should result in less funding-level volatility, the ride may still prove bumpy, especially if the market ‘prices in’ a Brexit and a vote to remain comes as a surprise. In this scenario we would expect to see the reversal of any built-up ‘pricing-in’ of a Brexit with investors being risk-off in the build-up and risk-on thereafter.
In either situation pension schemes should benefit from employing a well-diversified investment strategy and a governance structure that aims to capture positive funding level opportunities as they arise.
David Hickey is managing director, EMEA Advice Team, SEI Institutional Group
