Sunday 4 December 2016

Pension schemes can do without headache that's posed by Brexit

Paul Kenny

Published 15/04/2016 | 02:30

Prime Minister David Cameron helps to campaign for a 'Remain' vote in the forthcoming EU referendum at a phone centre in London today along with fellow pro EU campaigners, Lord Ashdown, Lord Kinnock, Tessa Jowell, Baroness Kinnock and Amber Rudd. Photo: PA
Prime Minister David Cameron helps to campaign for a 'Remain' vote in the forthcoming EU referendum at a phone centre in London today along with fellow pro EU campaigners, Lord Ashdown, Lord Kinnock, Tessa Jowell, Baroness Kinnock and Amber Rudd. Photo: PA

A report this week from IBEC reminds us of the possible challenges Brexit poses for the Irish, UK and broader European economy. For Irish pension schemes it adds unwelcome complexity to investment decisions, and is a headache that they could do without.

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The uncertain road to the UK vote on June 23 could lead to volatility in financial markets and requires careful consideration by pension scheme sponsors and trustees, and individual investors reviewing their pension portfolios.

Irish pension schemes already face a multitude of challenges: the ultra-low interest rate environment which makes it difficult for defined benefit (DB) pension schemes to remain solvent and increases the cost of purchasing annuities for defined contribution (DC) scheme members; and concerns over global economic growth and the knock-on impact on equity markets.

On top of this, we now have the looming 'Brexit' vote.

So how might this threat play out in financial markets and how might it impact pension schemes?

Most Irish pension schemes will have exposures of around 25pc of their equity portfolios to UK and Eurozone shares, and these markets will be directly impacted by Brexit. In the event of an "Out" vote, the volatility of UK share prices would likely increase and the UK stock market as a whole may underperform global stock markets.

Eurozone share prices may also weaken if international investors feel that the investment case for the EU as a whole is weakened by the UK exit.

How long any sell-off would last for will depend on how "clean" the UK exit is, and whether the issue is seen as a once off, or something more wide-reaching for the long-term future of the EU.

Falling or volatile equity markets are clearly not to be welcomed by pension schemes, but what about their bond market investments?

Irish pension schemes have a very limited exposure to the UK bond market, but the effect on Eurozone bond markets could have a big impact on Irish DB pension schemes, which on average have c.47pc of funds invested in debt issued by the various Eurozone governments.

The ECB's quantitative easing (QE) programme will remain the dominant factor for Eurozone bond markets in 2016, but Brexit could also have some impact if Eurozone bonds are seen as a better "safe haven" asset in a time of uncertainty for investors.

This may provide further upward pressure on the price of Eurozone bonds (and further downward pressure on yields).

Although the value of bonds held by pension schemes would increase, further falls in bond yields would spell bad news for pension schemes by increasing the pressure on DB schemes' solvency positions and increasing the cost for DC members of purchasing annuities. For investors worried about currency exposure, sterling weakness has been a feature since David Cameron announced referendum plans. Sterling weakness reduces the value of sterling denominated assets (eg, UK shares) in euro terms and so acts as a drag on asset returns for Irish pension schemes.

Although there is significant uncertainty as to how sterling would behave up to and post a Brexit, market commentators are generally expecting further weakness - for example, IBEC's report on Monday suggested sterling could weaken by a further 10-15pc and be close to euro parity if Britain votes to leave.

So, if the likelihood is that Brexit is bad news for Irish pension schemes, what should they do to prepare for the threat? Schemes should acknowledge that Brexit is a risk; and although in itself Brexit is only one of a range of risk factors in what is a complicated and volatile environment for investment markets, it needs to be considered.

Specifically, it is another useful prompt for pension scheme sponsors and trustees to ensure that their investment strategy:

1) Is diversified away from equity markets, with exposures to other assets such as corporate bonds, infrastructure and absolute return strategies; and that any equity allocations are spread globally.

2) Has a suitable allocation to bond assets, and where appropriate a process for DB schemes to increase the allocation to bonds should market conditions and scheme solvency levels indicate this is appropriate.

3) Has a "Lifestyle" strategy in place that is targeted at the likely needs of the majority of DC members, automatically reducing risk as those members approach retirement.

Markets keep moving, risks keep developing, and a proactive approach to investment issues, such as Brexit, is crucial.

Paul Kenny is a partner with Mercer

Irish Independent

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