By Dermot Dorgan
Britain is braced for one the most important votes in UK history. A ‘Brexit’ outcome in the EU membership referendum could change the destiny of the nation. It could also have implications for UK defined benefit pension schemes.
As the referendum day draws closer, trustees and scheme managers need to consider a number of important factors before considering whether they need to act.
First, let us examine the key economic implications. A Brexit would create new, more expensive trade relations with Europe and, at least initially, the rest of the world. Foreign direct investment (FDI) would fall for two reasons. Firstly, the EU represents 50% of the UK’s FDI. And secondly, non-EU investors would reduce their FDI, as the UK’s access to the EU’s single market would be inhibited. Indeed, foreign investors would be less likely to hold sterling assets in general. We would expect sterling to fall sharply on the news, but later recover.
Domestically, business investment and hiring would decline as trade and market regulations remained uncertain. Sterling’s depreciation would increase inflation, reduce real incomes, and hurt consumer confidence and spending. Higher government funding costs would mean, all other things being equal, lower government spending and/or higher taxes in the future – further denting private sector confidence.
From a markets point of view, we could see a 50bps sell-off in sterling credit spreads, or a 5% fall in the FTSE All Share. The question is whether temporary volatility is worth protecting against? And should Trustees consider potential consequences for European equities? Or should higher long-term rates and gains on foreign assets be welcomed?
It’s difficult to see clear strategic changes that would improve a scheme’s position in the long run. What further complicates the matter is that Brexit risk works in both directions.
If we were to create a Brexit scenario test, a ‘Bremain’ scenario test should also be considered. The market has been pricing the likelihood and impact of Brexit. We can see this most clearly in sterling’s depreciation since the start of the year. If the UK was to vote to remain in the EU we would expect this Brexit ‘risk premium’ to be unwound. Sterling, for example, would bounce.
So if investors are considering changes to their asset allocations in anticipation of Brexit, they should also consider how these changes would perform if the UK voted to remain.
In any case, over the life of a DB pension scheme, many economic and political shocks will be endured. Event risk is an ever-present evil. Knowing that we may be less than a month away from another, investors may feel compelled to act.
The reward from attempting to profit from these shocks is greatly outweighed by the benefits of sound long-term investment principles, among them clearly-defined goals, prudent investment constraints, and meaningful portfolio diversification. Effective risk management, expressed through both the strategic asset allocation and the decision-making process, will protect schemes from the markets’ vicissitudes, and that is where our physical and intellectual capital should be focused.
We believe investors should heed Peter Ustinov’s famous warning: “Don’t just do something, stand there.”
Dermot Dorgan is an ALM & Investment analyst at Redington.
