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Brexit to prompt change in DB pensions schemes’ reliance on gilts?

The result of Brexit may have been a shock to capital markets but may prove a catalyst in changing DB pension schemes’ reliance on gilts, says Hugh Ferrand, Head of UK Institutional Sales and Service, Invesco Perpetual…

The vote by the people of Britain to leave the European Union was a shock, not just for the UK but for financial markets and investors globally. The London Stock Exchange experienced its busiest trading day ever on the 24 June as markets reacted to a decision they had not expected. Shares globally had lost more than USD2 trillion in value by midnight. European mutual funds saw net outflows of EUR10 billion in June, after net inflows of EUR24 billion the month before.
UK defined benefit pension schemes were particularly hard hit and saw their liabilities shoot up from GBP820 billion to GBP935 billion in the four days after the referendum result, according to actuarial and investment consultancy, Hymans Robertson. The firm also calculated that 10 per cent fewer defined contributions participants would now be able to retire on an adequate pension as a consequence of Brexit.
That final forecast is predicated heavily on a decline in GDP, for the world in general but especially for the UK. But forecasting GDP is an art not a science and it may be that Brexit actually improves the UK’s economic productivity. Freeing the UK from bureaucratic rules and regulations from Brussels that slowed down business, was, after all, one of the arguments for leaving the EU. The OECD, having cut predicted growth for the UK this year to 1.7 per cent in June, has now raised that estimate to 1.8 per cent. So there is cause for hope that Brexit might work. How will this affect UK pension schemes?
That uptick in optimism from the OECD was in part thanks to the monetary response to the Brexit referendum result from the Bank of England. The immediate pledge of GBP250 billion of liquidity to the market and a cut in the lending base rate proved reassuring to equity markets, which subsequently recovered from their USD2trillion plunge. Some pension funds even cannily slipstreamed Brexit, taking advantage of the post-referendum spike in gilt yields to transfer to insurers responsibility for some of their liabilities. Two big trades saw GBP750m worth of liabilities pass from the ICI Pension Fund and GBP230m from Pilkington Glass.
Alas, not every scheme could make their desired swap or transfer of liabilities. Some insurers temporarily closed to new business prior to the referendum because of the uncertainty swirling around. By the time, they reopened, the Bank of England had worked its magic and yields were continuing their inexorable decline. So the huge wall of money waiting to move from pension funds to insurers remains.
That wall of money had been building long before Brexit. It has been accumulating since the last century and only gradually passing into insurers’ hands. The cost for companies that sponsor pension funds is high, hence the slowness of the process. But it is inexorable. The ICI scheme swapped a separate chunk of liabilities worth GBP605m just weeks before Brexit with another insurer. For these kinds of mature pension schemes, any trigger - Brexit, a vote of no-confidence in the government, a meteor striking Stoke-on-Trent – would serve the same purpose: a lift in yields and the chance to offload more liabilities.
Switches suit schemes with strong covenants and healthy funding levels, or both. But many defined benefit plans – in the UK and around the world – don’t find themselves in this happy situation. For those in the UK with heavy deficits – a funding level of 90 per cent or less - and inadequate rate hedges, the Bank of England’s post-Brexit actions have done more damage than good.
Patrick Bloomfield, a partner at Hymans Robertson, points out in a recent blog[1] that every time the Bank of England lowers base rates, it increases DB deficits, and that puts more pressure on trustees to hedge risk. These schemes, unable to pass on the risk to insurers, tend to buy more of the UK government’s debt instead. In previous times, this would be a sensible policy, offering reliable yields from an entity highly unlikely to default. Given that current yields on government debt promise you a loss in the real value of the money lent, the policy seems “absurd” to some senior pension fund trustees today.
Indeed, from the narrow window of opportunity presented by Brexit, the aggregate deficit of UK defined benefit schemes has since widened by a further GBP130 billion, according to Hymans Robertson. It’s not the only bad news. Returning to the OECD’s forecasts for UK GDP, there may have been a welcome uptick for 2016 but the leading economic think tank has cut its forecast for 2017 to just 1 per cent.
A weaker economy usually means a weaker currency so as shareholders of foreign companies, pension funds would enjoy a boost repatriating dividends and capital gains from abroad if sterling was worth less. But even the most adventurous pension fund has some UK holdings, notably all those bonds matching liabilities. Even if the government took advantage of its ultra-cheap borrowing rates to sink money into the economy in infrastructure projects, pension funds as gilt holders would be the ones ultimately paying for this Keynesian stimulus. Economists call this financial repression. The wealth from foreign holdings might provide some relief from this repression – although Brexit’s influence spreads far beyond the UK. But are there other ways that pension funds can break away from a reliance on gilts?
There is a famous line in the US mini-series Mad Men where Don Draper suggests that “if you don’t like what’s being said, change the conversation.” And perhaps this will now happen with DB pension schemes. Instead of valuing their liabilities referencing gilts, they will use a host of other assets. The Pensions Regulator is on the record as saying it is not a ‘gilts-plus’ regulator. And scheme-specific valuations mean just that: they can be composed specifically for each scheme. Gilts are not obligatory.
So what alternatives exist? The essential criteria for any new reference asset are a low probability of default and reliable income stream. The expensiveness of gilts is already driving many pension schemes to seek alternatives. And the solutions will come from the whole industry, not one particular scheme or actuarial firm.
There is evidence that the major investment consultancies are looking to bring alternative sources of income to their pension fund clients. Hymans Robertson alone has conducted more than 50 searches for forms of enhanced income, ie not UK gilts, from multiple sources of credit in the last two years. AonHewitt has conducted approximately 75 multi-asset credit strategies over the same period.
And so, fifteen years after Liability-Driven Investing began to take hold of pension fund management, a new chapter begins. The kind of alternatives in fixed income that pension funds have been adding rapidly to their asset portfolio look set to be part of the liability reference portfolio too. The more alternatives you own, the more suitable they will be as a liability reference. UK mortgages springs to mind as an annuity-like long-term, sterling-denominated stream of income. No doubt this will be expensive at first – change always is – but less expensive hopefully than holding gilts and letting the tail wag the dog.
The wider investment agenda might not take notice of this ‘change in conversation’ but it can be marked as one of the profound, unforeseen consequences of Brexit.

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